VOLUME 31 NUMBER 3 SUMMER 2019 Journal of APPLIED CORPORATE FINANCE IN THIS ISSUE: Columbia Law School Symposium on Corporate Governance “Counter-Narratives”: On Corporate Purpose and Shareholder Value(s) Corporate 10 Session I: Corporate Purpose and Governance Colin Mayer, Oxford University; Ronald Gilson, Columbia and Stanford Law Schools; and Martin Purpose— Lipton, Wachtell, Lipton, Rosen & Katz LLP. 26 Session II: Capitalism and Social Insurance and EVA Jeffrey Gordon, Columbia Law School. Moderated by Merritt Fox, Columbia Law School. 32 Session III: Securities Law in Twenty-First Century America: Once More? A Conversation with SEC Commissioner Rob Jackson Robert Jackson, Commissioner, U.S. Securities and Exchange Commission. Moderated by John Coffee, Columbia Law School. 44 Session IV: The Law, Corporate Governance, and Economic Justice Chief Justice Leo Strine, Delaware Supreme Court; Mark Roe, Harvard Law School; Jill Fisch, University of Pennsylvania Law School; and Bruce Kogut, Columbia Business School. Moderated by Eric Talley, Columbia Law School. 64 Session V: Macro Perspectives: Bigger Problems than Corporate Governance Bruce Greenwald and Edmund Phelps, Columbia Business School. Moderated by Joshua Mitts, Columbia Law School. 74 Is Managerial Myopia a Persistent Governance Problem? David J. Denis, University of Pittsburgh 81 The Case for Maximizing Long-Run Shareholder Value Diane Denis, University of Pittsburgh 90 A Tribute to Joel Stern Bennett Stewart, Institutional Shareholder Services 95 A Look Back at the Beginning of EVA and Value-Based Management: An Interview with Joel M. Stern Interviewed by Joseph T. Willett 103 EVA, Not EBITDA: A New Financial Paradigm for Private Equity Firms Bennett Stewart, Institutional Shareholder Services 116 Beyond EVA Gregory V. Milano, Fortuna Advisers 126 Are Performance Shares Shareholder Friendly? Marc Hodak, Farient Advisors 131 Why EVA Bonus Plans Failed—and How to Revive Them Stephen F. O’Byrne, Shareholder Value Advisors VOLUME 31 NUMBER 3 SUMMER 2019

IN THIS ISSUE: Corporate Purpose—and EVA Once More?

2 A Message from the Editor 4 Executive Summaries Columbia Law School Symposium on Corporate Governance “Counter-Narratives”: On Corporate Purpose and Shareholder Value(s) 10 Session I: Corporate Purpose and Governance Colin Mayer, Oxford University; Ronald Gilson, Columbia and Stanford Law Schools; and Martin Lipton, Wachtell, Lipton, Rosen & Katz LLP. 26 Session II: Capitalism and Social Insurance Jeffrey Gordon, Columbia Law School. Moderated by Merritt Fox, Columbia Law School. 32 Session III: Securities Law in Twenty-First Century America: A Conversation with SEC Commissioner Rob Jackson Robert Jackson, Commissioner, U.S. Securities and Exchange Commission. Moderated by John Coffee, Columbia Law School. 44 Session IV: The Law, Corporate Governance, and Economic Justice Chief Justice Leo Strine, Delaware Supreme Court; Mark Roe, Harvard Law School; Jill Fisch, University of Pennsylvania Law School; and Bruce Kogut, Columbia Business School. Moderated by Eric Talley, Columbia Law School. 64 Session V: Macro Perspectives: Bigger Problems than Corporate Governance Bruce Greenwald and Edmund Phelps, Columbia Business School. Moderated by Joshua Mitts, Columbia Law School. 74 Is Managerial Myopia a Persistent Governance Problem? David J. Denis, University of Pittsburgh 81 The Case for Maximizing Long-Run Shareholder Value Diane Denis, University of Pittsburgh 90 A Tribute to Joel Stern Bennett Stewart, Institutional Shareholder Services 95 A Look Back at the Beginning of EVA and Value-Based Management: An Interview with Joel M. Stern Interviewed by Joseph T. Willett 103 EVA, Not EBITDA: A New Financial Paradigm for Private Equity Firms Bennett Stewart, Institutional Shareholder Services 116 Beyond EVA Gregory V. Milano, Fortuna Advisers 126 Performance Shares: Shareholder Unfriendly? Marc Hodak, Farient Advisors 131 Why EVA Plans Have Failed—and How to Revive Them Stephen F. O’Byrne, Shareholder Value Advisors A MESSAGE FROM THE EDITOR

uring my nearly 40 years as editor, this journal has been devoted to exploring the idea D that public companies should be run to maximize their own long-run value. However much you may have been persuaded by the Business Roundtable’s recent statement that the idea has outlived its usefulness, it received a pretty remarkable show of support in an event that took place at Columbia Law School early this year—and that provides the main focus of this issue. by Don Chew

The event, which was nicely designed and themselves—or be required by law—to to enforce such statements of purpose, he orchestrated by Jeff Gordon and Kristin publish statements of corporate purpose expresses concern about the political risks Bresnahan at the law school’s Millstein that envision some greater social good associated with ever-more concentrated Center—and included an opening than maximizing shareholder value. And to ownership of public companies in a world statement by Ira Millstein himself—was carry out that purpose, he urges companies where populist distrust of all concentrations billed as a symposium on “Corporate to make continuous investments of their of wealth and power is clearly on the rise. Governance Counter-Narratives: On financial and other resources in developing But even more troubling for the Corporate Purpose and Shareholder their human, social, and natural capital— companies themselves is the confusion Value(s).” The occasion and organizing and also to account, quite literally, for such proposals are likely to create in focus were provided by publication of Colin such investments in much the same way corporate boardrooms. As Gilson points Mayer’s book, Prosperity—Better Business they now keep track of their investments out, corporate managements face not one, Makes the Greater Good. in physical capital. Although the author but two hugely costly ways of putting their Mayer himself, well-known corporate appears to prefer that such change be own interests ahead of their shareholders.’ finance and governance academic, and enacted through new legislation and One is the much cited problem of myopia inaugural dean of Oxford’s Said School of enforced by regulators and the courts, or short-termism, whose most common Business, launched the first of the five sessions his main energies are directed at enlisting form is underinvesting in the corporate with a 30-minute address that, without notes, the support of today’s largest owners of future to boost near-term earnings. (But slides, or AV equipment of any kind, issued a corporations, many of which—particularly if short-termism gets a lot of attention flawlessly articulate and stirring call for a “rad- wealthy founding families, institutional during the conference, Harvard Law’s ical reinterpretation” of what corporations are shareholders, and sovereign wealth funds— Mark Roe provides little if any support for supposed to do. The corporation, as Mayer are already favorably predisposed to ESG its existence or consequences in reviewing starts by pointing out, from its beginnings initiatives. the studies.) The other big problem, seldom 2,000 years ago in the Roman Empire until In their responses to Mayer, both the discussed these days, is what Gilson calls the rise of serious shareholder activism in the world’s most famous corporate lawyer, hyperopia, or overinvestment designed early 1980s, has combined commercial activi- Marty Lipton, and distinguished Columbia to preserve (low-return) growth and ties with a public purpose. But since Milton and Stanford law professor, Ron Gilson, the status quo. (And in the article that Friedman’s famous pronouncement in 1970 begin by suggesting that mandating such immediately follows the five Columbia that the social goal of the corporation is to changes is neither desirable nor feasible. sessions, University of Pittsburgh’s Dave maximize its own profits, the gap between Lipton, after praising Mayer’s proposals Denis provides a nicely compact review the social and private interests served by cor- and noting much common ground with his of three decades of research suggesting porations appears to have grown ever wider, own New Paradigm, also views the support that overinvestment is by far the more helping fuel the global outbreaks of populist of large shareholders as critical, and efforts widespread of the two problems.) protest and indictments of capitalism that fill to secure it as the most promising strategy. And as Gilson goes on to argue, perhaps today’s media. Gilson, on the other hand, sees a number the most challenging, and important, In Mayer’s vision, the boards of of major challenges to this approach. Apart responsibility of boards is achieving the all companies will either take it upon from the courts’ inability or unwillingness right balance in guarding against these two

2 Journal of Applied Corporate Finance • Volume 31 Number 3 Summer 2019 value-destroying tendencies—failure to social programs—especially protections for own long-run efficiency and value—that invest in the future, and failure to return workers and the unemployed—have been would be appropriate for, and end up capital to investors that will be wasted on put into practice by Northern European satisfying, all their different stakeholders. unproductive investment. Gilson’s answer to social democracies, the Judge responds “Who,” she asks, “would make the trade- the problem is simple:“better management,” to the more extreme demands of today’s offs among competing priorities when the as exemplified by, say, Costco’s ability to ESG movement by falling back on the pre- social purpose comes into conflict with operate profitably while—and perhaps scription of Columbia Law’s most famous economic value?” because—paying above-market wages. professor, Adolph Berle. Even while serv- Columbia Business School’s Bruce Kogut More generally, the answer is devoting ing as one of Roosevelt’s “Brain Trusters” closes the session with the suggestion that another dollar of resources to all important and framers of the New Deal, Berle also our greatest problems today may be coming stakeholders, as long as the present value of insisted that companies “stick to their knit- not from the shortsightedness and other the expected payoff—over any time horizon ting by putting shareholders first” as the failings of corporations, but from “deep, management is comfortable explaining to only way of ensuring the accountability of deep distrust of the competence of the state.” its investors—is at least a dollar. corporate managements and boards to the Kogut’s main prescription is that, to take A more direct and impassioned warning public. And in a provocative closing state- advantage of the enormous potential gains about the consequences of confusion about ment, the Judge warns that when thinking from effective arm’s-length collaboration the corporate mission was provided by SEC about ESG, between business and the public sector, Commissioner Robert Jackson, when com- governments at all levels should find ways menting in the third session on stakeholder [W]e ought to be very careful not to forget, to strike “Coasian bargains” with the theory and the role of corporate boards: or to confuse, what the Securities Acts were private sector—think what might have been about. It’s important that everyone understand between New York City and Amazon— Asking boards of directors to make major what corporations do—both what they are that make the best possible use of the core strategic business decisions while putting all supposed to do for society, and what they are competencies and resources of each. these different stakeholder interests on a par not supposed to do. That’s something everyone After a pair of articles by the University with shareholders’ imposes a decision-making should know, whether they own publicly listed of Pittsburgh’s Dave and Diane Denis— burden on the institution that we cannot and securities or not. Dave’s, already cited, on corporate should not expect boards to carry. Look, I’ve overinvestment and underinvestment, been in those boardrooms. They’re filled with Jill Fisch, co-director of the University and Diane’s, a clear and compelling good people who are trying to do the right of Pennsylvania Law School’s Institute restatement of “the case for long-run value thing. But the fact is that corporate boards do for Law and Economics, responds to the maximization”—the issue concludes with not hold the keys to our environmental future, Delaware Chief Justice by questioning reported sightings of a comeback by a or to ending inequality. They don’t have the whether corporate America in fact has measure of corporate performance called authority or knowledge or resources to solve a major governance problem. As Fisch EVA, or Economic Value Added, once a those problems. And expecting them to do that points out, U.S. companies have been regular subject in these pages. When I was is a prescription for profound unhappiness for taking voluntary measures—in some cases talking to Colin after the conference about millions of families who rightly feel let down even flouting thede regulatory initiatives the accounting challenge of capturing the by modern corporations. of the federal government—to address value of “non-financial” investments, Bruce Moreover, taking away companies’ clear, environmental problems; and like Costco, Kogut jumped in with, “I thought EVA single-minded objective function of increasing many have raised their workers’ wages well solved that problem years ago.” And in the long-run shareholder value raises real account- above market rates, while urging Congress last six articles in this issue, starting with the ability problems. Without such an objective, to increase legal minimums. And perhaps tribute by Bennett Stewart, the co-founder what will guide boards when making the diffi- most important, all this has taken place of EVA (and Stern Stewart & Co.), to his cult tradeoffs among stakeholders that effective not only without any legal challenges from co-founder Joel Stern, who died in May, oversight and management require? the companies’ largest shareholders, but we present a brief history of the rise, fall, generally with their encouragement and and apparent resurgence of EVA. As the last But in some ways an even more remark- applause—and higher stock prices. What’s three articles show, that comeback has been able statement of the so-called shareholder more, echoing Judge Strine’s concerns, accompanied by a sea change into forms primacy doctrine comes from Delaware Fisch closes by expressing skepticism rich and strange. Supreme Court Chief Justice Leo Strine. about the very idea that companies Shareholder value is dead, long live After invoking the New Deal, and express- are able to come up with a single social shareholder value! EVA is dead, long live ing admiration for the way its ideals and its purpose—other than maximizing their EVA! —DHC

Journal of Applied Corporate Finance • Volume 31 Number 3 Summer 2019 3 EXECUTIVE SUMMARIES

Columbia Law School Symposium on enacted through new legislation and have responded during the last 50 years to Corporate Governance enforced by regulators and the courts, his the forces of globalization and increased “Counter-Narratives”: On Corporate main efforts are directed at persuading pressure from investors by transferring the Purpose and Shareholder Value(s) the largest institutional owners of risks associated with product and worker corporations—many of whom are already obsolescence from their shareholders to favorably predisposed to ESG—to support their employees. Layoffs have generally Session I: Corporate Purpose these corporate initiatives. meant very large, if not complete, losses Colin Mayer, Ronald Gilson, and Marty Lipton, after expressing of “firm-specific investments” by displaced Martin Lipton enthusiasm about Mayer’s proposals, employees. And the problem is especially suggests that mandating such changes is troubling in the U.S., where the employees In this first of five sessions of a recent likely neither feasible nor desirable, but that of large companies lose not only their Columbia Law School symposium devoted attempts—like his own New Paradigm— jobs and income streams, but also often to discussion of his new book, Prosperity— to gain the acceptance and support of their connection to their social network, and The Purpose of the Corporation, Oxford large shareholders is the most promising to the entire system of social welfare and University’s Colin Mayer begins by calling strategy. Ron Gilson, on the other hand, insurance that tends to be provided by large for a “radical reinterpretation” of the after voicing Lipton’s skepticism about companies and the workplace. corporate mission. For all but the last 50 or the enforceability of such statements of While applauding corporate retraining so of its 2,000-year history, the corporation purpose, issues a number of warnings. programs, Gordon suggests that has combined commercial activities One is about the political risks associated individual company efforts are likely to with a public purpose. But since Milton with ever more concentrated ownership of be overwhelmed by the demand for such Friedman’s famous pronouncement in 1970 public companies in a world where populist services. The solution accordingly lies in that the social goal of the corporation is to distrust of all concentrations of wealth the form of government-provided social maximize its own profits, the gap between and power is clearly on the rise. But most insurance—in programs that, whether the social and private interests served by troubling for the company themselves is orchestrated and funded at the state or corporations appears to have grown ever the confusion such proposals could create federal level, provide the most cost-effective wider, helping fuel the global outbreaks for corporate boards whose responsibility government “match” designed to ensure of populist protest and indictments of is to limit two temptations facing the preservation of human potential and capitalism that fill today’s media. corporate managements: short-termism, or lifetime earnings power of employees. In Mayer’s reinterpretation, the boards underinvestment in the corporate future to of all companies will produce and publish boost near-term earnings (and presumably statements of corporate purpose that stock prices); and what Gilson calls Session III: Securities Law in Twenty- envision some greater social good than hyperopia, or overinvestment designed to First Century America: A Conversation maximizing shareholder value. To that end, preserve growth (and management’s jobs) with SEC Commissioner Robert Jackson he urges companies to make continuous at all costs. Robert Jackson. Moderated by John Coffee investments of their financial capital and other resources in developing other forms SEC Commissioner Robert Jackson of corporate capital—human, social, Session II: Capitalism and Social comments on three major issues the and natural—and to account for such Insurance Commission has been investigating: (1) investments in the same way they now Jeffrey Gordon. Moderated by Merritt Fox the concentration of ownership among account for their investments in physical American stock exchanges; (2) the extent capital. Although the author appears to In what Jeff Gordon describes as “the of common ownership of, and potential for prefer that such changes be mandatory, great risk shift,” large U.S. companies undue influence over, U.S. corporations by

4 Journal of Applied Corporate Finance • Volume 31 Number 3 Summer 2019 large institutional shareholders; and (3) the Northern European social democracies. to define a single social purpose (other than role of corporate boards in promoting and Most important are their protections for maximizing shareholder value) that would protecting stakeholder interests as well as workers and the unemployed—protections be appropriate for, and end up satisfying, shareholder interests. the Judge finds deplorably absent in all their different stakeholders. In the first of the three areas, Jackson U.S. law and corporate labor practices. Columbia Business School’s Bruce argues that the ownership of 12 of the 13 Nevertheless, when contemplating how Kogut closes with the suggestion that our U.S. stock exchanges by just three financial corporate boards in the U.S. might respond greatest problems today may be coming conglomerates suggests a competitiveness to the growing demand for U.S. public not from the shortsightedness and other problem—one that, despite the companies to address social problems like failings of corporations and corporate law, significant reductions in trading costs the environment and economic inequality, but from “deep distrust of the competence during the last 15 years, should receive the Delaware judge falls back on the of the state.” Kogut’s main prescription is further investigation. To the concerns prescription of Adolph Berle, who, though that to take advantage of the enormous raised by the common and increasingly one of the framers of the New Deal, insisted potential gains from effective arm’s- concentrated ownership of U.S. public that companies “stick to their knitting” by length collaboration between business companies by institutional shareholders, putting shareholders first as the only way and the public sector, governments at all the Commissioner’s main response is to of ensuring the accountability of corporate levels should find ways to strike “Coasian note that whatever culpability corporate managements and boards. bargains” with the private sector that America is forced to assume for our large Harvard Law’s Mark Roe responds makes the best possible uses of the core and growing environmental and social with a defense of corporate America competencies and resources of each. problems must be shared with the largest against the charge of corporate short- U.S. institutional shareholders, whose termism by noting that, although U.S. collective resources and influence confer capital expenditures have declined in the Session V: Macro Perspectives: Bigger a responsibility to help guide companies past 15-20 years, corporate investment Problems than Corporate Governance when responding to such problems. in R&D and other intangible assets Bruce Greenwald and Edmund Phelps. Finally, on the issue of stakeholder theory have both grown sharply. Corporate Moderated by Joshua Mitts and ESG, Jackson insists that asking distributions in the form of dividends and corporate boards to put the interests stock buybacks are rising, but so have the Columbia Business School’s well-known of all stakeholders on a par with their net borrowings of the companies making authority on value-based investing begins shareholders’ when making strategic the distributions, leaving the cash balances by attributing today’s economic problems to business decisions would be a mistake. of U.S. companies also near record levels. a “global economic dislocation,” one that is Besides creating a major accountability And the remarkably high valuations rooted in the ongoing—and in Greenwald’s problem, the adoption of stakeholder of successful high tech companies are view, inevitable—decline of manufacturing theory in place of “the clear, single-minded themselves forceful rebuttals of the idea and displacement by services. Like the objective function of increasing long-run that pressure from the stock market for other example of dislocation in modern shareholder value” would deprive boards current earnings is a serious deterrent to times, the Great Depression of the 1930s, of their principal guide “when making investment and innovation. the 2008 global financial crisis and the difficult tradeoffs among stakeholders The University of Pennsylvania’s protracted recession—still very much with that effective oversight and management Jill Fisch follows Roe’s dismissal of the us—are viewed as originating in the sharp of public companies require.” short-termism argument with even more decline of a major “sector” of the global forceful questioning of whether corporate economy. In the Depression of the ’30s America in fact has a major governance it was agriculture; in the recent financial Session IV: The Law, Corporate problem. U.S. companies have been crisis it was manufacturing. In both cases, Governance, and Economic Justice taking voluntary measures to address technological advances and economy-wide Leo Strine, Mark Roe, Jill Fisch, and environmental problems—in some cases productivity increases led to huge increases Bruce Kogut. Moderated by Eric Talley. even in the face of federal deregulatory in stock and financial asset prices—but initiatives—and many have raised their also to sharp drops in the prices of farm The Chief Justice of the Delaware workers’ wages, without any challenges and manufactured goods, and massive Supreme Court begins by invoking the (and often with encouragement) from their overcapacity and ruinous competition in New Deal, and expressing admiration shareholders. And echoing Justice Strine’s both sectors. for the way its goals and some of its social concerns, Fisch also ends up questioning According to the author, the working programs have been put into practice by the premise that companies can be asked off of overcapacity in the agricultural sector

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was accomplished largely by the effect of Is Managerial Myopia a Persistent investment policies and transferring control World War II in moving huge numbers Governance Problem? to outside investors—such as leveraged off the farm and into the mainly urban David J. Denis buyouts and recapitalizations, forced industrial sector at government expense. CEO dismissals, and shareholder activist This labor force relocation, which occurred Critics of U.S. corporations have long campaigns—companies tend to reduce, in all developed economies, was essential argued that companies are overly not increase, investment spending. In fact, to a global economic transformation focused on short-term results and, as a it is difficult to find any corporate control that for the next 50 years provided high consequence, sacrifice their own long- threats that have had the goal or effect of productivity growth and greater equality run value and competitiveness. These increasing investment. Third, and at the of income and wealth. criticisms have expanded in recent same time, the rising concentration of large More recently, however, the global econ- years to include those from prominent institutional investors, including indexers omy has been confronted with the challenge politicians, investors, consultants, and such as BlackRock and Vanguard, suggests of accomplishing a transition from manu- academics. If such criticisms have merit, that investors have become, if anything, facturing to services that will feature lower they would imply a massive governance more long-term oriented over time. Fourth, productivity growth and more inequality. failure in which there has been decades there is no evidence that the market shuns Foreseeing a long, difficult process, Green- of underinvestment with little adjustment companies that have yet to report large wald’s biggest concern is that government on the part of managers, boards, or the (or indeed any) earnings. These findings intervention will distract businesses from market for corporate control. suggest that curbing overinvestment, making this transition effectively—which This article evaluates the economic and not discouraging myopia and means continuing to operate as efficiently as underpinnings of these criticisms and underinvestment, may well still be the possible, downsizing when necessary—and analyzes their implications in the context larger corporate governance challenge so make the problems worse. And while busi- of empirical evidence produced by facing investors when monitoring and ness focuses on preserving its own efficiency several decades of research on corporate attempting to influence the performance and value, Greenwald urges governments to investment policies, the outcomes of of U.S. companies. look for more cost-effective ways—for exam- corporate control events, investor horizons, ple, expanded use in the U.S. of the Earned and the market pricing of companies with Income Tax Credit—to cushion workers little if any earnings. In reviewing the The Case for Maximizing Long-Run from the consequences. Nobel laureate findings of these studies, the author finds Shareholder Value Edmund Phelps, while agreeing with much little evidence to support the view that Diane Denis of Greenwald’s analysis, has a different expla- U.S. companies sacrifice long-run value nation of the U.S. productivity dilemma. and competitiveness by systematically Criticism of the shareholder model of Innovation is viewed as the primary driver underinvesting. corporate governance stems in part from of the prosperity of the advanced economies. First, although U.S. companies have misunderstanding about what shareholder Higher income and wealth matter less than indeed cut back on tangible investments wealth maximization means for the job satisfaction, participation, and an array such as property, plant, and equipment, other stakeholders of public companies. of non-material “modern values” that have these cutbacks have been more than offset The corporate goal of shareholder somehow been lost and that, for Phelps, are by the dramatic growth in investment wealth maximization does not imply the key to restoring economic growth and in intangibles, such as spending on that such stakeholders “do not matter.” “mass flourishing.” developing knowledge capital, brand- Managers maximize shareholder building, and IT infrastructure. Second, value by maximizing the expected when subjected to events that have the cash flows that are at least potentially effect of reducing managerial control over distributable to all of their stakeholders

6 Journal of Applied Corporate Finance • Volume 31 Number 3 Summer 2019 (after all have been given their his graduation from the University of accordance with what he refers to as “the contractual due). To maximize such Chicago’s School of Business in 1964, a accounting model of the firm”—often cash flows, managers must provide their 14-year stint at the Chase Manhattan Bank, leads to value-destroying decisions. As one customers with desirable goods and and the formation of Stern Stewart (and its example, the GAAP accounting principle services at attractive prices—which successor, Stern Value Management), Stern that requires intangible investments like in turn requires that managers attract traveled the world over, always eager to R&D and training to be written off in the employees, suppliers, and financial address and make converts among legions the year the money is spent is likely to capital needed to conduct their businesses of corporate executives, board members, cause significant underinvestment in such by providing each of these groups with and MBA students. One key to his success intangibles. At the same time, the failure market-determined returns on their was a passionate reverence for the academic of conventional income statements to contributions to firm value. In this way, scholars who developed modern finance. reflect the cost of equity almost certainly successful corporations benefit all of their Joel’s translation of the Miller-Modigliani encourages corporate overinvestment. stakeholders, and what is good for the valuation model into a practical framework Stern’s solution to this problem was corporation is generally good for society. for evaluating corporate performance an executive incentive compensation plan External forces such as the media and gained a following among a generation or whose rewards were tied to increases in government exert considerable influence two of corporate leaders, leading ultimately a measure of economic profit called on corporate actions and, in so doing, to the development of EVA, or Economic economic value added, or EVA, which they play a role in helping to limit Value Added, a practical framework for research has shown to have a significance negative corporate “externalities” such value-based financial management. relation to changes both in share value as pollution and climate change. But and the premium of market value over direct regulation of productive activities book value. Moreover, by combining such should be used sparingly, and subjected to A Look Back at the Beginnings of a plan with a “bonus bank” that pays out ongoing cost-benefit analysis. Government EVA and Value-Based Management: annual awards over a multiyear period, regulation replaces the collective decisions An Interview with Joel M. Stern boards could ensure that management of a broad marketplace of stakeholders Interviewed by Joseph T. Willett will be rewarded not for good luck using their own resources to act in their but for sustainable improvements in own interests with decisions made by In this interview conducted five years performance. government officials with complicated ago, one of the pioneers of value-based incentives and using resources generated management discusses his life’s work in by others. More generally, government converting principles of modern finance EVA, Not EBITDA: A New Financial should seek to regulate corporate actions theory into performance evaluation and Paradigm for Private Equity Firms only in the limited situations in which incentive compensation plans that have Bennett Stewart there are no market solutions for reducing been adopted by many of the world’s the effects of externalities. For example, largest and most successful companies, Private equity firms have boomed on the government plays a critically important including Coca-Cola, SABMiller in back of EBITDA. Most PE firms use it role in identifying and deterring corporate London, Siemens in Germany, and the as their primary measure of value, and ask fraud, and in ensuring competition and a Godrej Group in India. The issues covered the managers of their portfolio companies level playing field for companies and all include the significance of dividend payouts to increase it. Many public companies their stakeholders. (are dividends really necessary to support have decided to emulate the PE firms by a company’s stock price and, if so, why?) using EBITDA to review performance as well as the question of optimal capital with investors, and even as a basis for A Tribute to Joel Stern structure (whether and why debt might be determining incentive pay. But is the Bennett Stewart cheaper than equity). emphasis on EBITDA warranted? But the most important focus of In this article, the co-founder of Stern The co-founder of corporate finance the interview is corporate performance Stewart & Co. argues that EVA offers a consulting firm Stern Stewart and Co. measurement and the use of executive pay better way. He discusses blind spots and pays tribute to Joel Stern, the well-known to strengthen management incentives to distortions that make EBITDA highly popularizer of “modern corporate finance” increase efficiency and value. unreliable and misleading as a measure and consultant to hundreds of companies As Stern never tired of arguing, the of normalized, ongoing profitability. worldwide who died on May 21, 2019. widespread tendency of public companies By comparing EBITDA with EVA, or During a 45-year career that spanned to manage “for earnings”—or in Economic Value Added, a measure of

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Continued

economic profit net of a full cost-of-capital causes EVA to be negative when assets are Are Performance Shares charge, Stewart demonstrates EVA’s ability “new” and can discourage managers from Shareholder Friendly? to provide managers and investors with investing in the business. Marc Hodak much more clarity into the levers that These shortcomings led the author are driving corporate performance and and his colleagues to design an improved Performance shares, or PSUs, have become determining intrinsic market value. And economic profit-based performance the largest element of pay for top executives in support of his demonstration, Stewart measure when founding Fortuna Advisors in corporate America. Their spread was reports the finding of his analysis of Russell in 2009. The measure, which is called ignited by institutional investors looking 3000 public companies that EVA explains “residual cash earnings,” or RCE, is like for more “shareholder-friendly” equity almost 20% more than EBITDA of their EVA in charging managers for the use awards—as opposed to restricted stock changes in value, while at the same time of capital; but unlike EVA, it adds back and stock options, which have been providing far more insight into how to depreciation and so the capital charge characterized as “non-performance” improve those values. is “flat” (since now based on gross, or equity. Although that characterization has undepreciated, assets). And according to been challenged by many directors and the author’s latest research, RCE does a compensation professionals, proxy advisers Beyond EVA better job than EVA of relating to changes like Institutional Shareholder Services have Gregory V. Milano in TSR in all of the 20 (non-financial) continued to insist that the majority of industries studied during the period 1999 stock be granted based on performance, A former partner of Stern Stewart begins through 2018. compelling public companies to conform by noting that the recent acquisition of The article closes by providing two other to that standard. EVA Dimensions by the well-known proxy testaments to RCE’s potential uses: (1) a With over a decade of experience with advisory firm Institutional Shareholder demonstration that RCE does a far better PSUs, the evidence is in regarding their net Services (ISS) may be signaling a job than EVA of explaining Amazon’s effect: resurgence of EVA as a widely followed remarkable share price appreciation over • PSUs greatly complicate long-term corporate performance measure. In the last ten years; and (2) a brief case study incentives. Pay disclosures are dominated announcing the acquisition, ISS said that of Varian Medical Systems that illustrates by discussion of PSUs, including metrics, it’s considering incorporating the measure the benefits of designing and implementing goals, performance and vesting, and any into its recommendations and pay-for- a customized version of RCE as the differences in one grant year versus the next performance model. centerpiece for business management. over three overlapping periods. While applauding this decision, Perhaps the most visible change at Varian, • PSUs may be contributing to the the author also reflects on some of the after 18 months of using a measure the increase in pay. Companies issuing a shortcomings of EVA that ultimately company calls “VVA” (for Varian Value significant portion of their long-term prevented broader adoption of the measure Added), has been a sharp increase in the incentives in the form of PSUs have been after it was developed and popularized company’s longer-run investment (not granting about 35% more in value than in the early 1990s. Chief among these to mention its share price) while holding companies granting only restricted stock obstacles to broader use is the measure’s management accountable for earning an and stock options. complexity, arising mainly from the array adequate return on investors’ capital. • Shareholders don’t appear to be of adjustments to GAAP accounting. But getting anything for that added complexity even more important is EVA’s potential for and cost. S&P 500 companies using encouraging “short-termism”—a potential PSUs have underperformed their sector the author attributes to EVA’s front-loading peers, and companies using solely “non- of the costs of owning assets, which performance” equity have significantly

8 Journal of Applied Corporate Finance • Volume 31 Number 3 Summer 2019 outperformed their sector peers, and in believe that meeting consensus earnings is every single year over the last decade. more important than investing to maintain Given these findings on PSUs, it is time future earnings. EVA often doesn’t work for institutional investors and their proxy well because increases in current EVA advisors to reconsider their view of these often come with reduced expectations of vehicles as “shareholder-friendly,” and future EVA improvement—and reductions rethink their unqualified promotion of in current EVA are often accompanied their use by the companies they invest in. by increases in future growth values. Since EVA bonus plans reward current EVA increases without taking account of Why EVA Bonus Plans Failed— changes in expected future growth values, and How to Revive Them they have the potential to encourage Stephen F. O’Byrne margin improvement that comes at the expense of business growth and discourage Most companies rely heavily on earnings positive-NPV investments that, because of to measure their financial performance, but longer-run payoffs, reduce current EVA. earnings growth has at least two important In this article, the author demonstrates weaknesses as a proxy for investor wealth. the possibility of overcoming such short- Current earnings growth may come at termism by developing an operating model the expense of future earnings through, of changes in future growth value that say, shortsighted cutbacks in corporate can be used to calibrate “dynamic” EVA investment, including R&D or advertising. improvement targets that more closely But growth in earnings per share can align EVA bonus plan payouts with also be achieved by “overinvesting”— investors’ excess returns. With the use of that is, committing ever more capital to “dynamic” targets, margin improvements projects with expected rates of return that, that come at the expense of business although well below the cost of capital, growth can be discouraged by raising exceed the after-tax cost of debt. Stock EVA performance targets, while growth compensation has been the conventional investments can be encouraged by the use solution to the first problem because it’s a of lower EVA targets. discounted cash flow value that is assumed to discourage actions that sacrifice future earnings. Economic profit—in its most popular manifestation, EVA—has been the conventional solution to the second problem because it includes a capital charge that penalizes low-return investment. But neither of these conventional solutions appears to work very well in practice. Stock compensation isn’t tied to business unit performance, and often fails to motivate corporate managers who

Journal of Applied Corporate Finance • Volume 31 Number 3 Summer 2019 9 COLUMBIA LAW SCHOOL SYMPOSIUM Corporate Governance “Counter-Narratives”: On Corporate Purpose and Shareholder Value(s)

SESSION I: CORPORATE PURPOSE AND GOVERNANCE

Columbia Law School | New York City | March 1, 2019

Ira Millstein Colin Mayer Founding Chair, Peter Moores Professor of Ira M. Millstein Center for Management Studies, Global Markets and Saïd Business School at the Corporate Ownership, University of Oxford Columbia Law School

Jeff Gordon Kristin Bresnahan Richard Paul Richman Executive Director, Professor of Law and Millstein Center, Co-Director, Millstein Center, Columbia Law School Columbia Law School

Ron Gilson Marty Lipton Marc and Eva Stern Professor Founding Partner, Wachtell, of Law and Business, Lipton, Rosen & Katz LLP Columbia Law School; Meyers Professor of Law and Business, Stanford Law School

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here have been many recent and very public examples of T what is widely viewed as a breach of trust between corpo- rations and the public. For capitalism to survive and thrive going forward, we need to repair that trust. It is a multifaceted problem that will require multifaceted solutions. – Kristin Bresnahan

Kristin Bresnahan: Good morning, I’m many of which have been written by So, with that I’m going to turn the Kristin Bresnahan, Executive Direc- people in this room. We’ve all seen microphone over to the center’s founder, tor of the Millstein Center for Global headlines like “The Millennials and the Ira Millstein. Thank you. Markets and Corporate Ownership, and Younger Generations Are Souring on I’m especially pleased to welcome you Capitalism.” Ira Millstein: Thank you, Kristin. Good all to Columbia Law School and to the What does all this mean for the morning, everyone. Thank you all for Millstein Center’s conference: Corpo- future of American business? There joining us and coming out for this rate Governance “Counter-Narratives”: have been many recent and very public important discussion. On Corporate Purpose and Shareholder examples of what is widely viewed as a Today we live and work in a very Value(s). Today is going to be a fasci- breach of trust between corporations complex and constantly evolving capital nating day of great conversations, and and the public. For capitalism to survive market system, one that is filled with we’re very glad you all are here to take and thrive going forward, we need to both political and economic uncertainty. part in them. repair that trust. It is a multifaceted This means that corporations need to be When I started at the Millstein problem that will require multifaceted able to evolve with the changing times. Center last summer, one of the first solutions. The corporation has three legs: things Ira Millstein said to me was that Fortunately, we have gathered many management, the board of directors, he wanted it to focus on issues on the great minds that have spent a lot of time and shareholders. Management’s role corporation’s role in society and on thinking about these issues here today, has been vital from the beginning as exploring plausible alternatives to share- and they’re going to get us on the right the engine of corporate performance. holder primacy as the primary aim of track for exploring what we’re going to do For much of the 20th century, manag- and guide for managing corporate enter- about it. I’m very proud of the fact that ers exercised considerable control over prises. We both believe that such an we will be hosting conversations repre- public companies. But once passive exploration is a critical step in righting senting a wide variety of perspectives, boards are now embracing a more active the course of capitalism—which, while and I’m hoping that everyone here will role in oversight and planning. Over the producing impressive returns for share- be challenged to think about these issues past decade, a coalescence of economic holders during the last several decades, in a different way when they leave today. power has reinvigorated shareholders has contributed to environmental This conference is just the begin- into more active involvement with the problems and growing inequality. ning of a larger project that we hope companies they invest in. Once faceless Over the past eight months, the will frame research designed to answer groups of shareholders of different sense of urgency around these issues questions about how best to address varieties now have more significantly and the future of democratic capital- these issues, and in that effort we are concentrated power, particularly the ism has risen to the top of concerns of excited to work alongside and collabo- ability and inclination to wield consid- the collective consciousness, becoming rate with other organizations interested erable influence over the corporation the focus of presidential candidates, in the same goal, including the Coali- through its directors. much debated proposed legislation, and tion for Inclusive Capitalism and the Today’s reality is that shareholders countless books, articles, and op-eds, World Economic Forum. play a critical role in the success and

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irectors and corporations are not immune from the power of D the capital markets, the power of shareholders to impact stock price, and the ability to raise capital, executive compensation, and a host of other sensitive points. So for me, the looming question for all of us is this: Can we find a way to help public companies achieve the neces- sary balance between shareholder value and stakeholder demands, which may require shareholders to forgo shorter-term profit, either temporarily or even longer-term? – Ira Millstein longevity of a company. They provide and environmental change, human freedom and protection that directors the capital that corporations require rights, and the opioid crisis, are on the need to act? for growth—and just to sustain their rise. Corporations are being asked to Directors and corporations are not operations. So corporations cannot take the lead. The calls won’t go away. immune from the power of the capital turn a blind eye to shareholders or their These shareholder demands cannot markets, the power of shareholders to demands for faster and visible so-called be ignored. Rather, they now must be impact stock price, and the ability to “shareholder value.” And shareholder balanced with shareholder demands for raise capital, executive compensation, value, over decades, has become the short-term profits and price swings. and a host of other sensitive points. So shareholder primacy standard that So the management and oversight of for me the looming question for all of now prevails in corporate America. The a public corporation is a balancing act. us is this: Can we find a way to help corporation’s purpose was to generate And the question for all of us is: How do public companies achieve the neces- profit for shareholders. directors strike the right balance? Also, sary balance between shareholder value It has increasingly been argued that do the current institutional structures— and stakeholder demands, which may this mindset has inhibited growth and including existing laws, regulations, and require shareholders to forgo shorter- innovation while boosting shareholder incentive structures—encourage this term profit, either temporarily or even returns in the short term. And this balance? longer-term? mindset is now being challenged. The Under our existing legal frame- I believe these will be difficult challenge is coming from a variety of work, as long as directors satisfy their judgment calls based, we hope, on some forces and in unexpected ways from what fiduciary duties, the law gives direc- form of empirical studies. I have no we call corporate “stakeholders.” There tors incredible flexibility, principally answer yet for myself, only questions. is currently growing momentum from through the business judgment rule. First, the interests of management, a diverse group of stakeholders to think In fact, there are very few situations boards, and shareholders will have to beyond quicker profits. Such stakehold- where director decisions are subject be aligned—and this will require deft ers include not only the shareholders, but to the more stringent standards of handling. We can’t afford internecine also employees, suppliers, customers, and review of enhanced scrutiny or entire warfare. This implicates governance. the community from which the corpo- fairness. Directors should take solace But are we convinced that better ration draws its resources or that may from knowing they are legally empow- governance will improve corporate otherwise be affected by its actions. ered to make decisions they deem to be performance? Do we need this, or is it The most recent proxy season in the best interests of the corporation, obvious? Is it necessary? illustrates my point. Proxy demands which includes balancing stakeholder Do we need to consider a differ- for governance changes, including the demands when appropriate. But does ent form of governance such as private #metoo movement, gun safety, climate the current legal framework provide the equity? Do directors need to be more

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o the way I look at the ambition of today is that we had S a narrative, the Friedman approach—and really the ALI approach—in which the shareholders are first. But today we’re asking: Is that a sustainable story? And if it’s not, then what are the alterna- tives? – Jeff Gordon and better informed on corporate opera- a sustainable story? And if it’s not, then right time to be addressing these things tions and their extrinsic forces to make what are the alternatives? in a fresh way. informed decisions? Do we need some In thinking about today’s confer- Now let’s begin our first panel legislative or regulatory changes to ence, we have had the good fortune that with Professor Colin Mayer, who is accompany private efforts to balance? Colin Mayer, a distinguished Oxford the Peter Moores Professor of Manage- There are many more questions, many don, has written an exciting new book ment Studies at Oxford’s Said Business of which will emerge from this confer- that he calls “Prosperity”—one that School. Colin is also the academic lead ence. The conference, sponsored by provides what is, in several ways, a for the British Academy’s Future of the the Millstein Center, goes to the core radical take on some of these questions. Corporation program, whose mission of the center’s reason for being: gather- So, Colin is the anchor tenant for is to examine the changing relation- ing the best and brightest to raise even today’s event, and we greatly appreciate ship between business and society by more important questions and attempt his trekking across the Atlantic—and looking at the interaction between to provide the knowledge that lead to with Brexit maybe he’ll even stay, but statements of corporate purpose and answers as neutrally as possible, without you never know. public perceptions of business. He is bias or ideologies. We also thank His Honor Leo also a director of the energy modeling Strine for his willingness to engage in company Aurora Energy Research Ltd., Bresnahan: Thank you, Ira. Now, let me this debate today. We all know Chief and advises companies, governments, introduce Professor Jeff Gordon, who Justice Strine as a judge who puts all international agencies, and regulators is one of the co-directors of the Mill- the academics to shame, because he around the world. stein Center. has a day job and manages to produce Colin, the podium is all yours. more articles in the law journals than Jeff Gordon: Thank you, Kristin. I’ve most of the rest of us who don’t have Prosperity—and the Purpose of known Ira for almost my entire career the excuse of being a judge. And Bruce the Corporation as a legal academic. Ira and Mark Roe Greenwald, who is a Columbia business Colin Mayer: Thanks, Jeff, for the kind and I have been going at these issues for school professor who packs in students words. And thanks to you and Kristin a very long time. The fascinating thing in the courses he teaches, will also be for inviting me to participate in this is that although the questions are peren- here later in the day. wonderful conference. It’s a great plea- nials, the answers change over time. And So it’s going to be a day of narratives sure and privilege to be here. that’s because the owners of companies and alternatives to the narratives. And I’m going to talk about one of the change—and the markets and the world although the Millstein Center’s advisory most important institutions in our lives. change with them. board was, I think, the instigator of this It’s not the state, religion, or Columbia So the way I look at the ambition day, there are many on that board, and Law School. It’s an institution that of today is that we had a narrative, the many associated with the center, who clothes, feeds, and houses us, that Friedman approach—and really the ALI have different perspectives on these employs us and invests our savings, and approach—in which the shareholders questions: What’s the issue to be solved, it’s the source of economic prosperity are first. But today we’re asking: Is that and how do we solve it? I think it’s the and the growth of nations around the

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ompanies are not just nexuses of contracts. They’re also C nexuses of relations of trust based on principles and values enshrined and upheld by the board of directors. Now that notion of capitalism is also a coherent, self-contained idea—one that’s about solving problems by owners and boards of directors who are commit- ted to the solution of those problems by building up relations of trust with other parties. – Colin Mayer world. But at the same time, it’s been the backgrounds, and from very different leaders. And this is not just a post-finan- source of growing inequality and harm institutions and parts of the world, there cial crisis phenomenon; it’s been true for to the environment. In response to this was a really striking degree of consensus nearly all 35 years of the survey. double potential, for good and for ill, around three themes. Mistrust of business is profound, the British Academy and the National The first was the need for and pervasive, and persistent. Why is that Academy of the Humanities and Social urgency of change; the second was the case? I suggest the answer has a Sciences last January launched a major the reconceptualization of business; lot to do with the Friedman doctrine program of research that Jeff just and third was identification of the that there is one and only one social mentioned called “The Future of the instruments and the key policy drivers purpose of business: to increase profits Corporation.” required to bring about change. And while staying within “the rules of the It brought together more than 30 underpinning these three conclusions is game.” That principle has been the basis academics from across the humani- one key factor: the general loss of trust of business practice, policy, and teach- ties and the social sciences around the in business. ing around the world ever since. But it world, including many academics in Every year for the past 35 years, wasn’t always so. this country—including one now sitting Ipsos MORI, the market research Indeed the corporation was estab- right in front of me, Jeff Gordon! company, has been undertaking a lished under Roman law to undertake The objective of the program is to survey of which professions in Britain the public functions of collecting taxes, consider how business can and should people trust to tell the truth. At the minting coins, building infrastructure, change in the coming decades to address top, alongside doctors, nurses, and and maintaining public buildings. For the economic, social, and political teachers I’m pleased to say, come nearly all of its 2,000-year history, the challenges it faces, as well as the normal university professors. We might not corporation has combined its commer- commercial and financial ones; and have much power, pay, or prestige; but cial activities with a public purpose. how it should best take advantage of at least people trust us to do nothing, It’s only over the last 60 years that this the tremendous technological advances earn nothing, and take no credit for it. notion that there is only one purpose now in progress. Near the other end come business of business—to make money—has In November 2018, it published 13 leaders, just above realtors, professional emerged. It is this that is the source papers based on that research along with footballers, journalists, trade union of great inequality and environmental a report that summarized the findings. leaders, and, at the rock bottom, politi- degradation—and, I would argue, of What emerged was a remarkable degree cians. And this low esteem for business that pervasive mistrust. of consensus. Despite the fact that leaders is not just a bankers’ phenom- And the problem is only going to people all worked independently and enon; bankers are actually separately get worse because, while technology came from very different academic reported, and ranked above business offers tremendous opportunities for

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enhancing the well-being of society, it Two months ago, the Financial Successful businesses don’t profit from also poses serious risks. As technology Reporting Council and the Financial creating problems for people and planet. accelerates, so too does the lag between Conduct Authority issued a statement Instead, they commit to pursuing the business innovation and effective regula- about the stewardship of investment common purpose of the corporation, tory and policy responses. management businesses saying that such and they make a commitment to other But things are changing. Two firms should have a purpose that is not parties—customers, suppliers, local months ago, Larry Fink, the CEO and simply about maximizing the returns of communities—whose efforts in turn President of BlackRock, wrote a letter their beneficiaries, but also influencing contribute to that common purpose. in which he said that “every company the social policies of the companies in That sense of and commitment to needs a purpose—not a strap line or a which they invest. common purpose gives rise to recipro- marketing campaign, but a statement of There’s also been, as I’m sure you’re cal relations of trust, which provide the its fundamental reason for being, what it aware, a significant change in political basis of the mutual benefits that accrue does on a daily basis. Purpose is not the attitudes. to all the parties to the firm, including sole pursuit of profits, but the animating Elizabeth Warren has proposed her the shareholders. It gives rise to more force for achieving them.” And Fink is Accountable Capitalism Act, which loyal customers, more engaged employ- not the only leader of a multitrillion- would require corporations with ees, more reliable suppliers, and to more dollar asset management firm to have revenues of at least $1 billion to have patient and supportive shareholders and said that; the leaders of Vanguard and a public charter with a stated public prosperous societies. And that prosper- State Street have also weighed in with purpose. In France, President Macron ity in turn gives rise, in a virtuous cycle, much the same message. has suggested putting the notion of to greater revenues, lower costs, and Moreover, it’s not just the leaders of raison d’être at the core of the French therefore more profits for businesses. investment management firms that are commercial code. In Britain, the Labour Now underpinning the operation saying this. Britain, in some respects, Party opposition has reintroduced the of this cycle is the trustworthiness of led the world in setting corporate gover- idea of renationalizing the companies companies in upholding those corpo- nance standards. Since the Cadbury that Britain led the way in privatizing rate purposes. That trustworthiness is Committee set out in 1992 what has in the 1980s—an idea that would have dependent on the values of the business, become known as the Corporate Gover- been inconceivable just three years ago. their honesty and integrity, and cultures nance Code, those standards have Now all of this reflects a profound of commitment to those corporate provided the basis of corporate gover- change in people’s attitudes towards purposes. These three notions of nance codes for companies around the the role of companies in society; and it purpose, trustworthiness, and enabling world, including those governed by the illustrates the speed, breadth, and scale values are what underpins the critical OECD principles on corporate gover- of the change that’s in motion. But in factors that make possible a reconceptu- nance. particular, it reflects the fact that we alization of business in the 21st century. But last July, the Financial Report- need to reconceptualize our notion of To achieve this reconceptualization ing Council issued a new corporate business around why it exists, what it’s requires a fundamental rethinking of governance code that declared that the there to do, and why it was created—in four sets of policies: objective of corporate governance is other words, its purpose. Then business The first is in relation to law and not just to address the agency problem policy and practice should follow from regulation. Law, at present, we associ- of aligning managerial interests with and reinforce that purpose. ate with shareholder rights and the those of shareholders; corporate boards The purpose of business is not to fiduciary responsibilities of directors to are now also charged with ensuring that produce profits. The purpose of business promote the interests of shareholders. their companies give clear statements is to produce profitable solutions to the That’s a mistake. The law should aim of and then carry out their corporate problems of people and planet. Profits to promote corporate purpose and the purposes. It is the role of the board are produced as part of this process, but fiduciary responsibilities of directors to of directors to ensure that companies profits per se are not the purpose of do the same. make that commitment and have the business. Everyone who runs a success- We view regulation in a Friedman resources to make good on it. ful business knows that to be the case. context as setting forth and enforc-

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ing the rules of the game. But, again, as human, natural, and social assets. So, those four sets of policies around that should not be the primary aim of We should be measuring and recogniz- law and regulation, ownership and regulation. Regulation should instead ing expenditures on replenishing those governance, measurement and perfor- be designed to align corporate purposes assets as value-adding forms of invest- mance, and finance and investment are with public purposes in those compa- ment. And the profits of the companies the basis on which to bring about the nies where it’s appropriate to do so, in should be stated not just net of the cost desired change in business. None of particular in the case of utilities, infra- of physical capital, but net of the costs the proposed changes is radical; in fact, structure companies, private/public associated with maintaining human, many of them have already, in one form sector providers, and banks and audit- social, and natural capital. or another, been adopted. Consider, ing companies. In such institutions, it’s The final set of policies relate to for example, the creation of the public completely appropriate—and in fact finance and investment. In the past, benefit corporation, which has a stated critically important—to think about we have associated finance mainly with public purpose, alongside its commer- how one can align the private interests contractual arrangements between cial purpose. and purposes of companies with those suppliers and users of finance, partly The incorporation of licenses of the public interest. because the tax system favors debt over within statements of public purpose is A second set of policies relate to equity. But even when capital comes being seriously contemplated as a way ownership and governance. Owner- in the form of equity, it tends to be of addressing the problems associated ship today continues to be associated supplied mainly by dispersed share- with privatization to avoid the risk, with shareholders and, in particular, holders with whom it’s impossible for particularly in the U.K., of “renation- institutional shareholders. But owner- companies to have relationships. We alization.” The forms of ownership ship should be viewed as entailing not need to recognize that strong relation- that are required to produce relations just the rights of shareholders but their ships between investors and companies between companies and investors are responsibility and obligation to uphold are important both in the provision of commonplace around the world in the corporate purposes. There are many debt finance, particularly in the case of form of blockholders and, in particular, types of owners that are best suited to banks, and for companies seeking to family holdings. The corporate gover- performing that function in particular attract “relational” shareholders. nance reforms that I’ve just been talking circumstances. Examples are families, In so doing, we need to recognize about—those requiring board consid- foundations, employees, the state, as the potential importance and value of eration of social problems in corporate well as institutional investors. blockholders as well as dispersed share- decision-making—have already been Governance, as I just described it, holders. Moreover, corporate investment introduced in the U.K. has typically been associated with the depends not just on relationships with Lots of organizations have commit- agency problem of aligning manage- the private capital market, but also on ted themselves to measuring human, rial interests with the shareholders,’ but relationships with the public sector, social, and natural capital. There are as has been recognized in the recent because there are many areas–-partic- various ways of adjusting profits in corporate governance codes, the more ularly large, long-term infrastructure terms of, for example, impact invest- important, or overarching, goal may investment—where private capital ing that have been proposed. And the instead be aligning the interests of markets on their own are simply unable closer relationships between providers management with corporate purposes. to provide the types or amounts of of finance and users of finance is very The third set of policies relate to financing that companies need. much a feature of the way in which measurement and performance. At In such areas, it is especially impor- some banking systems operate, includ- the moment, we measure the finan- tant that there are strong relations of ing the close relationships between cial performance of companies by trust between government and business. private capital markets and public recognizing the costs of financial and It is there where the aligning of the sources of finance. This is important not material capital; but increasingly we’re interests of companies with the public just in terms of promoting the interests appreciating that what is actually interest is particularly important— of society and future generations, but more important in the 21st-century say, by including statements of public also in improving the performance of company are other forms of assets, such purpose in their charters or their articles. companies and their investments.

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I want to illustrate this point by sold, which customers they’re going been talking about in terms of a clearly introducing an example from the most to serve, and how the products are defined purpose, strong underlying troubled industry we’ve had during the marketed. What that does, of course, is values, a process of measuring perfor- last few years—namely, the banking to empower the branch and the branch mance in relation to human and social sector. But I am referring to one of the manager to make decisions. They don’t capital, and the relation of incentives to most successful banks in the world over have to refer decisions up all the time those measures of performance. It has a the past 20 or so years. It earned high in the organization. That allows those governance structure that is aligned with returns for its shareholders not only branch managers to build relations of the delivery of that corporate purpose before the financial crisis, but during trust with their customers, which gives in terms of the delegation of decision- and after the crisis. It’s one of the most rise to that observation of greater loyalty. making, and it has an ownership highly rated banks in the world. And it But what underpins the bank’s structure in which there are identifiable has one of the best credit ratings—and success with customers is the notion of “anchor” shareholders who are likely one of the best liquidity and solvency trust, of people working in the organi- to have the strongest interest in and ratios—of any bank in the world. zation, that allows that devolution and commitment to upholding that long- It’s also a bank with a clearly defined decentralization of decision-making. term purpose. purpose, a purpose that puts its custom- And what underpins that trust is a The significance of this arrange- ers first alongside the interests of its very strong set of values. Those values ment is in terms of the way in which employees—while at the same time it are firmly embedded in the people we conceptualize our notions of capital- also has an objective to be the lowest- who run those branches. The conse- ism. This is the point on which I want cost provider of any of its competitors. quences are that because of its more to draw this to a close. At present, we It’s succeeded in doing that for the past loyal customers, the bank has a more regard capitalism as an economic system 44 years. And it’s one of the fastest stable financial source. It therefore has of the means of private ownership of the growing banks in Britain. But it’s not a better financial performance and ratios means of production and their opera- British bank; it’s a Swedish bank—called than other banks. tion for profit, and we see ownership as Handelsbanken. One of the features But there’s a second interesting being a bundle of rights over the assets of this bank is that it has one of the feature associated with that element of of the firm that confers strong forms highest degrees of customer satisfaction, trust in the employees. It doesn’t pay its of authority on the possessors of those certainly of any bank in Britain, and in employees any bonuses. ownership rights. We view companies as most of Europe as well. We’re told all the time that you’ve nexuses of contracts that are managed And as one might expect, Handels- got to pay your employees a bonus. by boards of directors for the benefit of banken has inspired much greater Handelsbanken pays no bonus until their owners. loyalty among its customers. That’s a they retire at the age of 60—a truly That is a very coherent, internally reflection of what I was describing just long-term investment incentive—at consistent notion of capitalism; namely now as the reciprocal relations. Give, which stage they get a share in the private ownership for profit by owners and you will be given. What underpins profit-sharing scheme of the bank called that have strong forms of authority on this is the governance and the values of Oktogenen. other parties with whom it contracts. But the organization. The third interesting feature of there’s a parallel notion of what capital- One major underlying principle the bank is its ownership structure. ism is—that is, an economic and social behind the bank’s success is its devolved, It’s listed on the Swedish stock market. system whose mission is to produce decentralized decision-making down to It’s actively traded, but it has two profitable solutions for the problems the individual branches and avoiding dominant shareholders, one of which of people and planet by private and centralized control of the bank. Indeed is Oktogenen, which is the bank’s own public owners who do not profit from the bank’s mantra is; the branch is the profit-sharing scheme, and the other is producing problems for people or planet. bank. its Swedish industrial holding company Ownership is not just a bundle of rights, The branch manager makes called Industrivarden. but also a set of obligations and responsi- decisions about everything from the What this illustrates is that the bank bilities to uphold those purposes. pricing of products, what products are has exactly the principles that I’ve just Companies are not just nexuses

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of contracts. They’re also nexuses of of an alternative paradigm that is possi- rate governance debate over the years, relations of trust based on principles ble. And, to discuss that vision and to a world-class academic and a world- and values enshrined and upheld discuss the broader question of how we class lawyer, announcing the need for a by the board of directors. Now that go about building a counternarrative, radical change in the way we do business notion of capitalism is also a coherent, we have a remarkable panel to round out in order to avoid a populist apocalypse. self-contained idea—one that’s about what has been a great start to the day. I really can’t remember a similar conver- solving problems by owners and boards We’re going to start with Ron sation where the stakes are claimed to of directors who are committed to the Gilson, who is the Marc and Eva be so high—maybe hostile takeovers in solution of those problems by building Stern Professor of Law and Business the ’80s and activist investors now, but up relations of trust with other parties. at Columbia Law School and Meyers these claims always reflected a signifi- What aligns the private interest Professor of Law and Business emeritus cant amount of hype—and we’re going of companies with the public inter- at Stanford Law School. Ron is also a to have the conversation with just the est, according to the traditional model Senior Fellow at the Stanford Institute right people. For that reason alone, our of capitalism, is a combination of of Economic Policy Research, a Fellow discussion should be fascinating. competitive product markets, labor of both the American Academy of Arts I’m going to address, in my Warhol markets, and financial markets—and, & Sciences and of the European Corpo- moment, both Colin’s presentation and in cases where markets fail, regulation. rate Governance Institute, and he was its compatibility with the work that But what underpins the need for this one of the reporters of the American Marty has done in his “New Paradigm.” alternative view that I’m talking about Law Institute’s Corporate Governance My focus will be on three general points. is that between market efficiency and Project. Ron’s academic work focuses The first is to ask whether in fact Colin regulatory effectiveness, there is a void; on the law and economics of corpo- and Marty have the issues framed right. and this void is increasingly becoming rate governance and acquisitions, along The second is how do we get from these a chasm as technology accelerates, and both comparative and domestic dimen- broad statements of principles to the as evidence proliferates of both market sions, and on the economic structure of claimed better place. The third is a more failures and government failures. transactions and complex contracting, general and more troubling problem: In that void we rely on business including venture capital contracting. does the link between managerialism to transform our private self-interest and the defense of capitalism against into collective, communal interest in a Legal and Political Challenges to the populist hordes confuse corporate common purpose. To do that we depend Corporate Purpose governance and real governance? on the trustworthiness of companies to Ron Gilson: Thank you, Kathryn. I’ll start with Colin’s remarks. uphold and contribute to that sense of Following Colin is always a difficult role; Colin tells us that we require a “radical purpose. Trust is one of the most impor- the combination of a spectacular presen- reinterpretation” of the nature of the tant and largely unrecognized assets of tation style and equally interesting ideas corporation. That reinterpretation companies, because ultimately a trust- is bound to give you a sense of sweep- involves each company’s board creating a worthy corporation is a commercially ing up after elephants. But that said, I sacred text that sets out the corporation’s successful corporation and the compet- very much appreciate the opportunity purpose in some larger way—something itiveness of nations depends on the to participate in this panel. Sweeping between a little red book and a mission trustworthiness of its corporations—for up after elephants is an important task. statement—whose end is to cause the the prosperity of the many, not just for As I expect will be repeated through- company, through the exercise of craft- the few, and for the future as well as the out the day, this is a very unusual ing such a statement, to focus on the present. Thank you very much. moment in corporate governance. way the company’s business and its Colin’s presentation and, soon to come, interests interact with broader social Kathryn Judge: Thanks, Colin. And Marty Lipton’s provide perspectives on a policy. Under current circumstances, for those of you who haven’t read it, set of issues that are as important as any I Colin tells us, neither the sharehold- Colin’s book does a remarkable job of can recall in my 40-some years of study- ers nor current corporate governance laying out, in much greater detail than ing corporate governance. Here we have practice succeed in aligning corporate what we’ve just heard, a coherent vision two leading participants in the corpo- and social interests.

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y simple prediction is that large institutions… will shift their M indexed holdings to the most socially responsible manager… and they’ll take a little bit of reduction in return because that in fact is what the managers of their beneficiaries want… [T]he result will be to shift… to a different set of activists. One set was after money— and maybe you can make a deal with those people. The other is driven by principle, which is harder to compromise. If my concern… proves right, the problem then is less socialism… but rather an activist-driven Green New Deal. – Ron Gilson

Marty, as I understand the motiva- on management decision-making, even shareholder can hold. Here the problem tion for the New Paradigm, is pretty if management gets to define them. is the framing of the dilemma that has much on the same page. Marty puts it But this difference in formal imple- brought us here today: in a period of well when he says, “Capitalism is at an mentation isn’t critical, I think, because genuine and warranted concern about inflection point.” And in another nicely Colin’s formal reinterpretation of the income inequality, the idea of concen- turned statement, he says, “The prioriti- board’s duties to require a statement of trating control of major corporations zation of the wealth of shareholders at the broad purpose is effectively unenforce- in a small number of families or in expense of every other stakeholder has able other than through ownership. management is not an issue of just given rise to a deepening inequality and To be sure, Colin floats the idea that a corporate governance. It’s an issue of populism that today threaten capitalism fiduciary duty can be imposed on direc- real governance. In the U.S., we assign from both the right and the left.” tors to follow the corporate statement distributional decisions to those who The New Paradigm is Marty’s of purpose—and that, if the board does are politically accountable for them, response to this pincer threat to not pursue that purpose, courts will and allocational decisions to those capitalism. He envisions an implicit intervene to decide whether the balance who are disciplined by the market. partnership between corporate gover- among shareholders and other stake- Putting control over distributional nance and stewardship. An implicit holders was struck correctly. I expect decisions in boards of directors that, partnership, of course, is not a partner- that this proposition will strike every however diverse along other dimen- ship at all; it’s a group of people who corporate lawyer in the room as utterly sions, are made up of older rich people have shared interests and voluntarily act implausible—Colin’s fiduciary duty is a who are accountable to no one hardly in ways that reflect that overlap—people business judgment-style standard that is seems like a response that will placate my age will recall Kurt Vonnegut’s highly unlikely to have any bite. the populists. At any rate, dealing with concept of a “karrass” in Cat’s Cradle. And that leads us to where Colin’s distributional issues requires thinking That kind of partnership will allow talk ended—namely, to the structure about how we run our democracy, business to address what for Marty and of corporate ownership, and to Colin’s not our corporate democracy, and is Colin is the real culprit—one that we attraction to families and other kinds hardly going to be resolved by changes all know well from the rhetoric of the of controlling blockholders. Colin in corporate governance. Put bluntly, last 10 years: corporate “short-termism.” notes that two management-related neither Colin’s radical reinterpretation Here Marty’s view differs at the shareholders hold 20+% of Handels- nor Marty’s new paradigm will placate edges from Colin’s. Marty typically has bank’s voting power with a charter Jeremy Corbyn in the U.K. or Bernie not favored imposing legal restrictions limit of 10% on the votes any single Sanders in the U.S.

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I now want to come back to Colin balancing short-term and long-term work. The result was the American and Marty’s framing of what seems to considerations when managing compa- Law Institute’s “Principles of Corpo- be the underlying problem: the curse nies is a very difficult task, maybe the rate Governance,” which turned out of corporate short-termism. Each of greatest challenge facing managements to be a way to marginalize Schwartz’s them I think has it half right. Markets and boards. And for investors, distin- effort. Academics understood what was sometimes lack information that guishing between shortsighted and happening. If something’s going on that management has but cannot easily well-disciplined managements—and you don’t like, what’s the answer? We share with the market, and so can cause between farsighted companies and those study it. If we study it long enough, the management to choose an investment for whom the payoff will never material- Hirschman cycle runs—as it did in the horizon that is too short. But such ize—is often impossible. case of federal incorporation. market myopia is only one side of the With that setup, what do we make So the puzzle today is this: On problem. The other half is that manage- of this joint Anglo-Saxon refram- both sides of the Atlantic, there’s been ments can also be “hyperopic” when ing of corporate governance? Albert a Hirschman-like swing of the pendu- assessing the promise and value of their Hirschman is the author of what is lum toward public interests. What’s current strategy. widely viewed as the most important going on? Here I offer just a specula- Governance, whether it’s a radical piece of informal corporate governance tion—or more, really, a question to both reinterpretation or a new paradigm, scholarship. It’s a book called Exit, Colin and Marty. On Colin’s side of the confronts a single core problem. When Voice, and Loyalty. Near the beginning, Atlantic, one can’t help but note the we’re operating through a board and Hirschman asks: “How do I identify sharp difference between Colin’s radical through management, how does the when, in the face of a poorly perform- reinterpretation of corporate law and board distinguish between two cases: ing organization, when we should leave, Jeremy Corbyn’s and the Labour Party’s where the market lacks manage- when we should yell, and when we approach to the same set of issues. ment’s private information, and so should stay?” Labor’s agenda, as I read the short-termism is likely to be the Getting this question right is, as I newspaper accounts, is renationaliza- problem—and where management is suggested, one of the biggest challenges tion, worker representation on corporate holding what amounts to an out-of-the- facing boards. And so I want to direct boards, limits on dividend payments, money call option on their career and so you to a different Hirschman book that and some other pretty intrusive initia- behaves just the way that option pricing speaks to the set of issues that Colin tives. Colin’s proposal of requiring a theory predicts—that is, the value of and Marty talk about: that business has corporate purpose beyond maximizing management’s position is increased by dug itself so deep a hole that we can’t profits seems radically more favor- extending the option’s duration, making climb out of it without making social able to management. I have no idea, the argument that if their shareholders interests an integral part of corporate though Colin may, about any corre- are patient and give them more time, the governance. The book is called Shift- spondence between the timing of the expected payoffs will materialize. ing Involvements: Private Interest and British Academy project and Corbyn’s The old General Motors and GE Public Involvement. There Hirschman succession to Labour Party leadership. currently provide examples of such lays out an endogenous, long cycle in We see the same thing on our side of hyperopia. A third example is closer which public concern shifts back and the Atlantic. Senator Warren’s Account- to home for me: PG&E deferring forth between private interests and the able Capitalism Act that Marty refers maintenance of transmission lines and public interest. to essentially covers much of the same so providing Northern California both To illustrate the working of ground as, and shares many of the electricity and fires. So, we also have this cycle, I remind us of one piece aspirations of, Corbyn and the Labour evidence of managerial skewed beliefs of history. Long ago in a galaxy far Party. about the future payoffs from their away—Marty will remember it—people Let me close by talking about the current strategies. became concerned that the efforts of a feasibility of the two presentations. Both myopia and hyperopia are Georgetown academic named Donald Focusing on feasibility is not to deny important problems. And in some Schwartz to persuade Congress to the power of the underlying theme, but cases, identifying them isn’t hard. But federalize corporate law might actually rather to think about how we might get

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from here to there. I’ve mentioned my voting for ESG-based proxy proposals argued positions is not about the goals concern with Colin’s framing—that to accommodate the perceived prefer- they hold up—it’s how do we reach the courts won’t enforce it, and that ences of their own beneficiaries; the them. A different, but more realis- the concerns of populists are not likely fund managers think such voting will tic answer is just better management. to be met by creating an even more attract asset flows, and this behavior— Take Costco, a big box store that treats unequal distribution of power within which is not necessarily consistent with its employees well but still competes the country. Marty’s solution, as one value maximization by companies or extremely well against Sam’s Club, might expect from a very good lawyer, is their investors—is an example of what which does not. There is more than one more technical. Here I will just suggest Jeff Gordon and I call the “agency costs way to run a company; and if we can that the real question being asked by the of agency capitalism.” do a better job of persuading institu- New Paradigm isn’t a matter of corpo- Point Four: The three largest index tions that good managers, rather than rate governance; it’s really a matter of holders have different records with short-sighted (or excessively optimistic) asset management. respect to voting on climate change. managers, are what we want, we may do For example, Exxon has tried to Vanguard is the least climate friendly. better than radical reinterpretations and keep off the ballot an institutional BlackRock’s somewhere in the middle. new paradigms. investor-backed proxy proposal requir- State Street is much more friendly. And ing greater disclosure of the impact of the differences are not insignificant. Judge: That was great, Ron, thanks. climate change on Exxon’s business. The Point Five: My simple prediction is Last but certainly far from least is proponents included a sovereign wealth that large institutions who are the index Marty Lipton, founding partner of fund with $1.2 trillion under manage- funds’ customers will shift their indexed Wachtell, Lipton, Rosen & Katz, who ment. Although $1.2 trillion sounds like holdings to the most socially responsi- advises major corporations on mergers a lot, it’s actually not. There’s another ble manager—that is, the manager that and acquisitions and matters affecting group, Climate Action 100+, with votes the way the 323 institutions in the corporate policy and strategy. Marty 323 institutional investors as members Climate 100+ want; and they’ll take a is the author of The New Paradigm— that in the aggregate have assets under little bit of reduction in return because A Roadmap for an Implicit Corporate management of $32 trillion. That that in fact is what the managers of their Governance and Stewardship Partner- number can be significant if there is an beneficiaries want. ship, which argues that corporations issue that joins that group—that makes Point Six: The result will be to shift and shareholders can forge a meaningful them an implicit partnership. And that the shareholder activists that Marty and and successful private-sector solution to does concern me. Colin have been concerned about for attacks by short-term financial activists. I have six points of concern. the past ten or fifteen years to a differ- Point One: The first point starts by ent set of activists. One set was after Some Thoughts on The New noting that the business of the three money—and maybe you can make a Paradigm large index holders is pretty straightfor- deal with those people. The other is Marty Lipton: Thanks, Kathryn. When ward. Profitability depends on massive driven by principle, which is harder to I listened to Ira’s introduction, I said to economies of scale, and hence on compromise. If my concern about the myself, it’s only people of our age—Ira’s attracting assets. way institutional investors will push and mine—who are able to realize that Point Two: Asset flows in the index money managers to vote proves right, this discussion has actually been going fund industry, in contrast to active the problem then is less socialism, on for a very long time, and that most management, don’t depend on the whatever the term means these days, of the major issues are still not settled. managers’ performance because perfor- but rather an activist-driven Green New And I’m not quite sure how we’re going mance by definition does not differ Deal. However, good shareholders are to settle them. Ron Gilson, as you might among competitors in terms of returns at one thing or another, and design- expect, pretty much summed up my (only in terms of fees), and the price ing cost-effective responses to climate views exactly as I would state them, so differentials are marginal. change probably isn’t one of them. I won’t repeat what he has said about Point Three: A large and growing That said, I’ll stop. But, again, my them. Ron was also right in saying that amount of institutional assets have been concern with two enormously well my views pretty much coincide with

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o what do we do about all of this? One overriding concern of S mine has been regulation and legislation. It seems to me that the history of the world has shown that, as you increase the amount of legislation and regulation, and you move away from competi- tive market determination of these basic economic issues, you move toward and even encourage a totalitarian approach to government and its concomitant, economic failure. – Marty Lipton

Colin’s, and that Colin has written a the organizations that have been estab- economic failure. If you look at the truly unique and magnificent book. lished have aimed to focus capital on the history of socialism and communism Let’s start with the amazing scope of long term. Consider, for example, the from their beginnings to the present, the book. Like the history of the corpo- Coalition for Inclusive Capitalism—or you see either failure and abandonment ration, the book really does start 2,000 some of the older organizations like the of socialism, or the rise of totalitarian years ago and work its way up to not Council of Institutional Investors and governments that become only more just the current time, but even extends ISS—and I could spend the rest of my extreme over time. Even as in the case into the future. I think that if we’re ever ten minutes just listing these organiza- of China 30 years ago, when a new going to solve the problems that we’ve tions and their goals and proposals. regime comes in aiming to create a been discussing, this book is going to And the law reviews are replete market economy, it often doesn’t take provide the basis, or the framework, with articles calling for and offering long before you end up with a totalitar- for solving them. Now, I’m not saying blueprints for fundamental changes in ian regime. that the book has provided definitive corporate governance. In fact, I got my And with that sense in mind, I’ve answers to our problems; but there’s first major lesson in dealing with law always felt that it’s important to try and no question that the book—and the reviews in 1979. I wrote an article that solve the problems without government comments of Colin and Ron and Mats flew in the face of the Chicago school regulation. Ron aptly made reference to this morning—do a great job of identi- of economics, and they’ve been after me Ralph Nader and that point in time. fying and articulating all the important ever since—with my detractors urging The issue back then was not corpo- issues. So, we’re no longer dealing with me to recant, or at least defend, my rate governance. It was really about something where we don’t understand arguments, and my admirers urging me antitrust; and the debate ended up what the issues are. What we’ve come to write more articles. without any conclusions or resolution. to recognize is that we are dealing with So what do we do about all of this? But the ALI spent the next 13 years pretty complicated issues that are very One overriding concern of mine has mulling things over, and accomplish- difficult to resolve in ways that end up been regulation and legislation. It seems ing absolutely nothing. I have the two satisfying the majority—hopefully the to me that the history of the world volumes on my office shelf there; and vast majority—of people. has shown that, as you increase the if you remove all the dust, you’d find a But clearly we have not reached that amount of legislation and regulation, bright blue cover. But no one ever looks point of agreement or consensus—in and you move away from competitive at them anymore. fact, it’s just the opposite. I’m not sure I market determination of these basic Now there’s a new effort underway. can count all of the new paradigms that economic issues, you move toward and Ed Rock is going to try and do a restate- have been proposed in the last half dozen even encourage a totalitarian approach ment of corporate governance, and I’m years to address the problem. Some of to government and its concomitant, sure it will turn out to be an excellent

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work. But I have my doubts that it ity of shareholders and investors, I’d say institutions. And so my thesis should will solve any of these problems. And there are still major disagreements. To discuss the changes in corporate law I should confess that I have the same me, it seems clear that the concept of that had to take place to accommodate doubts about my own New Paradigm. stewardship holds the key to solving this movement. As I mentioned, there are a lot of the problem. Take Elizabeth Warren’s Well, I failed. So instead of going organizations and propositions. I wrote stakeholder bill. Basically what it does back to NYU to be a corporate law a proposal for the World Economic is to impose classic stakeholder gover- professor, I ended up practicing law. But Forum a few years ago called the New nance on corporations with a billion every time I see Jack Coffee, I promise Paradigm that focused on the issues dollars or more in revenue each year. to send him a bundle of the articles I’ve of corporate governance and investor The problem with that solution is that, written since then, and I expect him to stewardship. Although it was published unless the shareholders—who today send me my degree. I have sent him the in September of 2016 and handed out own approximately 80% of all large articles, but he hasn’t sent me the degree. at forum in Davos in January of 2017, it corporations—support the principles hasn’t gotten much of a hearing. of stewardship, you’re not accomplish- Questions from the Audience: Since then, a relatively new group of ing very much. Judge: As much as I would love to take major investors and large corporations If BlackRock and State Street and moderator’s privilege, I think it’s impor- called the Investor Stewardship Group Vanguard all come out and say, we’re tant we have a little time for questions has encouraged me to come out with an for purpose and culture, we agree with from the audience. updated version of the New Paradigm. all of this, but then continue to vote for Like the first version, the revised New proposals by activist hedge funds, then Michael Graetz: There are at least three Paradigm consists of principles for we don’t accomplish anything. And important changes that have happened both corporate governance and inves- that’s what’s happened. There’s nothing since Milton Friedman announced what tor stewardship, and principles meant to new in the New Paradigm, and there’s you’ve described as his rule; and none guide engagements of and interactions really nothing new in the last 30 years. of the speakers has emphasized any of between corporate boards and investors. But the competitive features of the them. I think each of them has made All of these principles are consistent investment management business have the problem harder and the solutions with those you heard about from Colin essentially prevented a real resolution more elusive. earlier: purpose, commitment, trustwor- of the problem. Unless we can get the One is that the markets have thiness, and culture. I think we can all major investment institutions to buy become ever more global under circum- agree that those are the issues that we’re into supporting purpose and culture, stances where the rules remain largely dealing with and need to be solved. And we will not solve the problem. national. The second is that the share- I continue to believe that we can solve Kristin just held up a zero to me, holder ownership of public companies them. which either means I’m out of time— has actually become global, and is For example, there is not much or my whole approach to this was a becoming ever more global over time. dispute today about what corporate zero, and I should leave knowing that The third, which I think is really most boards and corporate management I have failed. I failed once before here important in raising the concerns that should do. There have been arguments in Columbia. I came here in 1955 as are leading to these proposals, is that about that over the past 30 years, and a teaching fellow to get a JSD degree business—at least in the U.S.—has they’ve all been resolved. Almost every studying under Adolf Berle. I arrived become politically dominant in a way it major corporation today pretty much with great enthusiasm—and Mr. Berle was not when Friedman made his rule, follows a set of corporate governance was really a terrific person. He had only or when the ALI was really studying the principles that everybody else—whether one fault. He insisted that he would first time. they believe the principles or not— accept no thesis other than one that Management has been effective seems willing, or at least resigned, to discussed the changes in corporate in seeking benefits for its sharehold- follow. So there’s not much debate going law that would result from the fact ers not only in the marketplace, but on now about board responsibilities. that shareholdings were moving from in the political realm. And this success But in the case of the responsibil- individuals into pension funds and has exacerbated the maldistribution of

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income and wealth, since the share- more ethically. But the reality is that Sixty years of research on the subject holders are mostly in the top part of Bosch has clearly been implicated in the has produced absolutely no conclusion the income distribution. This creates Volkswagen emissions scandals, and it’s on the subject. So I couldn’t possibly a particular frustration that can be now pled in the Fiat Chrysler scandals. argue that that is the central underpin- expressed in only electoral, but not legis- In fact, Bosch seems to have been the ning of the book. Short-termism is not lative politics; it’s in the legislative arena entity that spread the emissions fraud all what it’s talking about. It’s talking about where the businesses are dominant, not across the auto industry. And this leads contractual failure, regulatory failure, in the electoral arena. And this risk me to think that even if companies are governance failure. associated with electoral politics adds to privately held and therefore more closely The book also does not say that all the risks that Colin and others have bound to long-term interests—at least family ownership is the solution, or even described. in theory—such entities may not be desirable. Indeed, I say that I don’t expect And I’m not sure that Colin’s notion particularly interested in acting ethically that family ownership will be revived in of corporate purpose would really trans- if it gets in the way of profit. Britain, which I cite as a country that form the role of business in the political So this tees up this issue: How do we has very effectively extinguished family realm. Maybe it would, depending on exert and maintain pressure for corporate ownership. what the purpose was. For that reason, it purpose in the absence of shareholder On the other hand, I do think the seems to me that limiting business influ- primacy, or at least shareholder pressure, first question about the increasingly ence in the legislative arena should be which we’re talking about as being a global nature of markets and sharehold- somehow worked into the statement of source rather than potential solution to ers becoming more global is extremely purpose for that to happen. the problem? It doesn’t make sense to go important. That development is giving back to something that’s totally private rise to the phenomenon of the “universal Lipton: The problem I see with your unless we can figure out how to maintain owner”—the idea that we all collectively, proposal is the beginning of state corpo- pressure for purpose and ethical action in by virtue of our holdings in investment ratism. It’s the problem we really want to that sphere. firms like Vanguard and BlackRock, hold avoid. As you get companies into govern- So, Colin what would be the struc- the entire global portfolio. As univer- ment, you encourage government to tural mechanisms that could bring the sal owners and global indexers, we’re get into companies. I think one of our ideas of “companies” back into the not influenced, or even much inter- mutual objectives is to avoid state corpo- corporation and not allow the kind of ested, in the performance of individual ratism, because it does lead ultimately to abuses that we are still seeing in private stocks. We’re interested in managing the totalitarian government. companies? systemic risks—that is, the political risks, the environmental risks, the trade protec- Josephine Nelson: Colin, you mentioned Mayer: Before I respond to that question, tion and regulatory risks. Those risks are the value of closer relationships between let me thank everyone here for a tremen- the things that move the stock markets investors and companies, providers of dous set of comments and observations and the indices. capital and users of capital, and how throughout. What that basically says is that differ- that’s likely to encourage long-term And to start with the panel, let me ent kinds of ownership perform different investment. respond to Ron’s really very well articu- functions. The role of index funds is For example, you hold up the lated retort to precisely what the book extremely important in allowing you and relationship banking of Handelsban- doesn’t say. If you look at the index, me to incur very low transaction costs ken as a model. But, in the book, you it doesn’t mention the word “short- when investing in equities around the also mention Bosch, one of the largest termism” or “myopia” or any equivalent; world, and by so doing, allow companies private corporations in the world, as and that is because the book doesn’t talk to raise capital on economic terms. At the a particular example of where a trust about short-termism. And that’s because same time, the shareholder activists play owns a corporation and therefore it’s a I’m not sure I believe that short-termism a very important role in terms of provid- private entity. In theory, private entities is a problem; at the very least, I don’t ing precisely the interest in individual are supposed to be more interested in think we know how to identify and corporate performance that the universal long-term profits, and so should act measure short-termism. owners don’t.

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But because that interest is short- more global, their impacts on society ated with a separation of business and term by its nature, it is extremely are not just national in nature. They government, requires a close relation- important that we have anchor block- too are global, not simply because they ship between government and business in holders that provide the third form of are multinationals, but because their the provision of so-called “public” goods ownership, which has interest in individ- products are now global. Think Google. such as education and health, and large- ual companies that is long term in nature. Think Facebook. The implication here is scale, long-term infrastructure. That may take the form of families, but is that traditional government mechanisms I’d just like to end by addressing the increasingly taking other forms. Particu- are not well positioned to deal with the question that Professor Nelson raised larly promising are engaged institutional challenges to privacy and anti-compet- about how one reconciles trustworthy investors, such as the Canadian pension itive concerns that such companies business with corporate scandals and funds and some sovereign wealth funds present. whether private ownership is the appro- that hold large blocks in individual The second feature of change has priate solution. The evidence that comes companies. been that the assets of companies have from surveys of trust in family business The book talks about the benefits altered completely from being predomi- suggests that they are more trusted of diversity of ownership, and the need nantly tangible assets to essentially than other types of firms. In particu- for that diversity to correspond with the intangible assets today. That means lar, employee satisfaction appears to be purposes of companies. In the U.K., that those assets are not predominantly greater in family than other businesses. partly through misguided regulation, material. They are embodied in forms of Employees feel more cared for, better we’ve extinguished blockholders by human, social, and natural capital. The treated and valued; and, as a consequence, making it basically impossible for them implication of this is to turn the tradi- they are more committed, devoted, and to continue their control of companies. tional view about legitimacy on its head; motivated—a further example of recipro- The notion that my book is in any way that is, the legitimacy that was derived cal benefits, of give and be given. aligned with what Jeremy Corbyn is from the property rights over the assets Nevertheless, there is one respect in proposing is wrong; it’s exactly what of the firm is becoming irrelevant as which family firms appear to underper- Jeremy Corbyn is not proposing. The companies are increasingly dependent on form and that is in regard to their wider current Labour Party is probably the least human, social, and natural capital; and contribution to society. They seem to likely political body to adopt the sugges- instead corporate responsibilities to such view their employees and local commu- tions in this book. forms of capital—not their rights—have nities as part of their wider families, but I thought that Mats’ comments really grown. that does not extend to society and the got to the central issues around what I And that brings us to the role of environment more generally. would view as matters of “legitimacy”— government in performing these public So I do not see family firms or private legitimacy about what companies should functions and, as Mats put it, promoting firms in general as a panacea, and I do be doing and what ownership should be freedom. The trouble with the conven- not believe that we will see a return to about. Our current views on ownership tional view of freedom is that, while large-scale family ownership in Britain. are that legitimacy derives essentially competitive markets are important, it Instead, we should look to reform in from a property rights view of the firm— also requires another element, which public equity markets through more that owners are owners of the assets of the Marty very correctly referred to in terms long-term, engaged institutional investors firm in the same way as they own any of the capabilities of people to exercise as a way of addressing their deficiencies. other property. And that confers those choice effectively. And there are some encouraging signs strong rights as well as serious responsi- The ability to exercise choice derives that this is beginning to happen. bilities on owners in the way in which I from people’s ability to maintain not just describe them. their purchasing power over commodi- Bresnahan: Thank you to our panelists But, again, as the first questioner ties but also the relationships that are for their open discussion of this critical observed, there have been very substan- involved in terms of their delivery and topic. We’ll look forward to hearing from tial developments in three dimensions. people’s fulfillment of what they see as all of them as we continue to explore The first is that, because companies their own purposes. Defined as such, the these themes at the Millstein Center. have become much larger, and much freedom that is conventionally associ-

Journal of Applied Corporate Finance • Volume 31 Number 3 Summer 2019 25 COLUMBIA LAW SCHOOL SYMPOSIUM Corporate Governance “Counter-Narratives”: On Corporate Purpose and Shareholder Value(s)

SESSION II: CAPITALISM AND SOCIAL INSURANCE

Columbia Law School | New York City | March 1, 2019

Merritt Fox Jeff Gordon Michael E. Patterson Richard Paul Richman Professor of Law; Professor of Law and Co-Director, Center for Law Co-Director, Millstein Center, and Economic Studies; Columbia Law School Co-Director, The Program in the Law and Economics of Capital Markets, Columbia Law School

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Merritt Fox: I’m Merritt Fox, Professor which no single firm is able to offer thick the firm, suggests that forces outside of Law at the Columbia Law School, enough insurance, including income the shareholder body might be given a and it’s my pleasure to introduce Jeff preservation insurance, to compensate governance role. Gordon, who, as Kristin told you earlier, workers, especially aging workers, for the The focus of my talk is economic is the Richard Paul Richman Professor shrinking job security associated with insecurity, which I think we all under- of Law and Co-Director of the Millstein technological change and obsolescence. stand to be of great importance. Center for Global Markets and Corporate So, to me the big question here is: Presumably there is a strong corporate Ownership at Columbia Law School. Jeff What is the right form of government governance feature to the risk of downsiz- is also a Fellow of the European Corpo- match for the economy we have? I devel- ing and layoffs. By contrast, although rate Governance Institute. And as you oped some of my thinking on this in an inequality is also a serious problem, I know, he and Kristin have been the spark- article in the British Academy Journal think that corporate governance plays plugs in organizing this conference. issue that Colin put together, and I’ll try a secondary role in its creation and to summarize that thinking here. persistence. Although Thomas Piketty’s Jeff Gordon: Thanks, Merritt. This talk is, research identified executive compensa- to some extent, responsive to Colin, but Diagnosing the Problem tion as a major source of inequality, I it will come at things from a somewhat As I see it, the current malaise consists think the more fundamental sources of different angle. The question I want to of three elements: inequality, economic inequality are quite different. They relate raise is whether “corporate governance” insecurity, and slow economic growth. to the structural changes in the nature of as we’ve been discussing it is capable of Corporate governance has to do with the work and the different ways that some playing the important role in addressing way power is exercised within the firm. firms succeed, and some do not. social problems that we’ve assigned to it. Although the legal framework of corpo- David Autor’s work, for example, on And so, unlike Colin, I want to start by rate governance has remained stable over the “superstar firm” shows huge inequal- asking whether, or to what extent, the a very long period of time, the impli- ity across companies in the pay of people social challenges we face can be dealt with cations—or the actual workings and with the same jobs. The secretaries at at the level of the firm—that is by specific effectiveness—of that framework have Google, for example, would be extremely corporations and their boards. This was, varied greatly during the 40 or so years well paid. Their wages would be not only I think, the basic assumption of what we I’ve been in this business. And what’s much higher than those of most secretar- heard this morning. become clear to me during this period ies across the Bay Area, but also probably The alternative perspective is that is that these changes in governance are a good deal higher than those of the the fundamental issues are more clearly at bottom a function of major changes middle managers of many smaller public viewed as the economic and social effects in corporate ownership. The dispersed companies in the area. More generally, of a dynamic and global market economy ownership of the Berle-Means corpora- the high compensation that tech firms in which companies operate and are tion of yesteryear gave managers effective pay their armies of software engineers forced to compete. Rather than focusing control. In those days, collective action has exacerbated the sense of “inequality” on the firm as the unit of greatest concern, problems muted shareholder voice. throughout the Bay Area. And along with and assuming that companies themselves Today, the re-concentration of ownership Autor, I would argue that the compen- are responsible for, say, retraining workers into the hands of institutional investors sation consequences of disparate levels whose skills have become obsolete, whose means that shareholder activism can effec- of economic success across firms and “human capital” has depreciated, I think tively challenge managerial prerogative. industries is a more profound driver the real issue is one of social insurance, So, it’s the interaction between the legal of inequality than high levels of CEO of ensuring that we have the right form framework and ownership that creates the compensation or rewarding corporate of government “match” to ensure the corporate governance environment. efforts to increase profits by controlling preservation and, where possible, the Corporate governance is very labor costs. And so, from this perspective, reinvigorating of human potential over much in the news. Senator Warren’s addressing inequality is not fundamen- the lifetime of employees. Designing proposal for codetermination—that tally a corporate governance issue. and implementing this kind of insur- is, significant labor representation on In a YouTube video that went viral, ance is critically important in a dynamic boards—was mentioned earlier. Colin’s Dutch historian Rutger Bregman told a economy like ours—an economy in book, which focuses on the purpose of Davos audience that the way to address

Journal of Applied Corporate Finance • Volume 31 Number 3 Summer 2019 27 ROUNDTABLE inequality is “taxes”—particularly, estate U.S. turn toward economic nationalism companies are funded and managed, is taxes—and all the rest is beside the and neo-mercantilism by the Trump the mechanism by which those external point. Estate taxes are the way to address administration surely disrupts long-term market pressures are transmitted to their inequality, not a focus on firm level planning and investment. employees. And this creates the economic decision-making. It also seems to me that many politi- insecurity that, as I’m suggesting, is not so Similarly, I don’t think that “corpo- cians who attack buybacks are really much a governance as a social insurance rate governance” has much to say looking for companies to provide a kind issue. It’s not something that companies about slow economic growth, though of Keynesian stimulus—that is, a way can address acting alone. purported corporate governance defects to drive the economy by spending not So the resulting policy prescrip- have been blamed. Assertions that stock government funds, but more shareholder tion focuses on the need for a new buybacks produce cutbacks in R&D capital, to promote a boom. Whether match between government and enter- and prevent significant investments that shareholders get a competitive return prise—one that recognizes the role of would promote an economic boom are on that investment is the least of politi- government, perhaps in collaboration contradicted by the careful marshalling of cians’ concerns—though it does seem with the private sector, in renewing evidence by Jesse Fried and Charles Wang to matter to shareholders. In short, the human potential as a lifetime concern. in a recent issue of the Harvard Business rate of economic growth turns on factors Once upon a time, government financed Review and related work. Their research other than firm-specific levers of corpo- education K through eight. In the U.S., indicates that buybacks occur predomi- rate governance. the “high school” movement of a century nantly in those economic sectors where So, again, I think economic insecu- ago expanded that to K through 12 and, the ROI is low, meaning that managers rity is really where the deep issues lie here eventually, through the state educa- (and companies) are returning money to in the U.S. In this country, when you lose tion systems and federal subsidies, to K the shareholders because they don’t have your job, you’re cut off from the social through 16. Companies could presum- good investments to make on their own. network. You lose not just the income ably provide that initial training—but There are of course other expla- stream, but the entire system of social they don’t, because it’s inefficient and nations for this slow growth. Robert welfare and insurance that is effectively because we expect government to play Gordon, for example, argues that the supplied and funded by, and run through, that role. really big inventions—like electric- the company and the workplace. And Well, given that companies operat- ity—aren’t going to happen again. And needless to say, that’s a real loss. ing in the dynamic economy of today are alongside something like the invention So if there’s a big idea here, it’s that not able to provide the kind of insurance of automobiles, the Internet just doesn’t the present environment has produced they once did, it seems to me that the really cut it. But from casual conversa- what I call the “great risk shift.” There’s right move is to think about more effec- tion, I think many business executives been a risk shift away from the share- tive ways for governments to extend the don’t share Gordon’s pessimism. holders, who now can and do diversify match they provide enterprise, towards One plausible argument focuses on away all firm-specific and idiosyncratic maintaining lifetime human potential, in the negative effect on growth of erratic risks, and toward employees and all the building and sustaining human capital. government policy, which can make it other stakeholders who benefit from And I want to be clear that this is not difficult for companies to contemplate and indeed depend on the existence primarily a redistribution of wealth. significant investments with long-term and stability of particular corporations. There’s obviously some element here of payoffs. For example, the fiscal auster- The result of this dynamic, as mediated using some of the gains from workplace ity policies that were widely followed through corporate governance, has been flexibility and ensuring that people after the outbreak of the financial crisis to shift risk from shareholders onto the displaced by it get compensated to some exacerbated and prolonged the Great employees, who are far less able to bear extent. But much more than redistri- Recession in the U.S. and Western that risk and insure against it. Employee bution, it’s first and foremost a more Europe; during those years, companies payoffs are firm-specific; not so for the effective allocation of social resources focused on survival not expansion. Four diversified shareholder. Companies are designed to increase social wealth, the years ago, we weren’t sure if the euro was subject to strong pressure from product size of the overall pie that ends up getting going to survive; what’s the right payoff and capital markets; and corporate divided by all corporate stakeholders. The horizon facing that risk? And the abrupt governance, viewed as the way that economic rationale for “layoffs,” after

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he right move is to think about more effective ways for T governments to extend the match they provide enterprise [with K-12 or K-16 education] towards maintaining lifetime human potential, in building and sustaining human capital. – Jeff Gordon all, is that they preserve or increase value one way that diversified investors can act by, say, charging higher interest rates or by preventing companies from wasting to reduce the level of systematic risk. So insisting on lower leverage. The manag- resources—potentially valuable human if you think that some system of broader ers of the firm can also adjust; after all, capital—that might be put to higher- social insurance, particularly this mainte- we pay them in stock-based pay, which value uses. nance of human potential over a lifetime, encourages them to take these risks. That at least is the theory of is part of not only increasing expected Increasing managers’ upside will thus “constructive” layoffs, if you will. But in returns across the portfolio or across the make them risk-neutral or even risk- the modern economy with technological economy, but also at mitigating a certain seeking. But it’s the employees who change and obsolescence, layoffs tend to sort of political risk, then the question is, are unable to adjust to the extra risk mean a very large, if not complete, loss of what position should the asset managers arising from the changed incentives that “firm-specific investments” by displaced play in moving towards this consensus? diversification provides shareholders to employees. The aim of this government These so-called “universal investors” hold encourage more corporate risk-taking. match I’m envisioning is a social invest- the shares of all the companies. They have Think about the way that the organi- ment in our workforce, a rebuilding of the vision to perceive what’s going on. zation of companies has changed in the the human capital that has been lost. And The question is, how involved are they past 50 or 60 years. The conglomer- the ultimate purpose of this match is to going to end up in politics, and what ates of the 1950s and 1960s proved to make society as a whole more productive does that do to their business model? be failures, in significant part because in dealing with some of the demographic Let me elaborate a bit on this diver- investors who wanted diversification issues that the U.S. and other countries sification point, because I think it’s key could get it at the portfolio level. Such are now facing. to understanding the world in which we investors don’t need, and so won’t pay And let me make one quick final live, in particular the “great risk shift” up for, diversification at the firm level; point about the interesting position of the that I referred to previously. It was a and as had become clear by the end of Vanguards and BlackRocks, the indexed Nobel Prize-winning idea that inves- the 1970s, firm-level diversification asset managers, of the world. The product tors should aim to maximize their utility introduces new expenses and other ineffi- they offer is not a firm-specific invest- by achieving the highest risk-adjusted ciencies. It requires managers to oversee ment, but a low-cost diversified portfolio expected returns, meaning attention to a broad range of businesses, many of of all companies in the economy. And risk as well as returns. The follow-on them with no operating synergies. And if that’s your product, the only way that investment strategy is portfolio diversi- it’s “managerialist” in the sense that the you can improve the outcomes for your fication, which minimizes firm-specific size and scope achieved by this kind of investors is by increasing expected returns idiosyncratic risk. “empire-building,” which has the effect and lowering systematic risk across the of reducing efficiency and value, actually portfolio as a whole—that is, the entire Economic Insecurity benefits managers because it buffers economy. What are the real world implications? performance variation across the firm’s Now, how could institutional inves- It means that investors want companies diverse businesses. tors mitigate systematic risk? If you to be aggressive in taking business risks, Who else ends up being protected think that some of the disruption we while being willing to accept the greater through the diversification of a conglom- see at the individual firm level creates risk that such companies will fail. erate? Apart from management, it’s political risks to stability—and we’ve What are the consequences for other really the employees, because the result- seen evidence of that in the political parties to the firm? Creditors of the firm ing diversification of the profits and realm—then stability-seeking becomes can adjust to such increased risk-taking operating cash flow means that the

Journal of Applied Corporate Finance • Volume 31 Number 3 Summer 2019 29 ROUNDTABLE conglomerate will be less likely than a structured—all in pursuit of the highest way the world has turned that’s created focused, single-business firm to lay off risk-adjusted returns. the problem, and the solution requires a employees of a unit that’s in trouble. As a consequence, we now have different sort of match between govern- Cash flows in a conglomerate can be a system that is extremely efficient in ment and enterprise. reallocated to protect a failing unit; the utilization of resources. But one employees can be shifted to more profit- regrettable, though unavoidable, effect Questions & Answers able divisions within the firm. of such efficiency is the shifting of risk Fox: Thanks very much, Jeff. We have But starting in the early 1980s, the from shareholders to employees. And, about 15 minutes for Q&A. Let me decades-long process of dismantling again, I don’t see any way for companies take the privilege of the chair to give you the conglomerate structure initiated by to insure employees against this kind the first question. I think you very neatly corporate raiders and LBO firms helped of risk. There’s no way for the firm to mapped out the current situation in bring about this major shift of risk from provide a relationship that would make terms of the power of BlackRock and the the shareholders to employees—a change the employees whole against the firm- other large index funds in their poten- that, as I suggested, is partly attributable specific risk that they’re exposed to. tial to influence corporate governance. to investors’ growing reliance on low-cost Hence my call for a government But at the same time you’re arguing that diversification methods. With the rise solution. If we’re going to have this high- corporate governance isn’t the solution of hostile takeovers in the 1980s—and powered governance system—one that to our problems. Can you speculate a running more or less continuously to keeps our companies responsive in a little bit more about whether you think today’s shareholder activists—we have dynamic global economy—then I think these large asset holders should be play- seen a high-powered governance system we also need government to play a bigger ing some kind of political role? whose main goal is to eliminate corpo- role in helping retrain employees. And rate “slack,” or inefficiency, as seen from this is not a problem that neo-mercan- Gordon: There are two different ways to a shareholder point of view. tilism can solve. With companies like play a political role. One is a direct role The big difference between today Walmart, Amazon, and Netflix completely in buttonholing folks, lobbying. That’s and the 1970s and the 1980s is that the disrupting the way business is done, politics in a direct sense and raises many amount of slack, or value left on the table, a disproportionate share of the risk of concerns. The other is stating what they that it would take to trigger corrective change is being borne by employees. And believe to be the case, trying to shape the action is much less today. The dispersion unless we’re willing to tax the disrupters debate by offering informed views. of share ownership in the ’70s and ’80s themselves—and in so doing, discourage Of course folks can disagree about meant that collective action problems the process of innovation—I think we what they think are the underlying could be overcome only through the have to consider other, presumably state- problems. When Larry Fink says the expensive mechanism of a hostile or tax-funded, forms of social insurance. goal is getting companies to invest for takeover bid, in which a buyer faced At the very least, then, I’m providing the long term, and that that would solve all the risk of a misjudged opportunity. a call for a rethinking of social insurance, the problem, then I think the diagnosis Today’s reconcentration of ownership has for a kind of lifetime human potential he offers is not helpful; it pushes us away invigorated the proxy battle, which can insurance. Now, this is not a codeter- from policy that would be constructive be pursued at much lower cost than a mination strategy. That wouldn’t solve on dimensions that I’ve described. By hostile bid, and in which a shareholder the problem; it doesn’t get us anywhere. suggesting that if individual companies activist bears only the risk of its toehold And we can view this not as an issue of and their managers only behaved better, stake, not 100% ownership. The conse- fairness or redistribution or part of the were more far-sighted—and maybe if we quence is that companies now have much safety net—although those are all legiti- only got rid of the activists, or maybe if less margin for what is perceived as strate- mate framings of the problem—but we moved to Colin’s system, we could gic or operational shortfalls. rather as an economic question of the change things—we’re ignoring the crux To summarize my point, inves- optimal kind and amount of investment of the problem, at least as I see it. But if tors’ diversification has made profound in retraining workers, in reinvesting in you accept my view that global competi- changes in not only how parties invest, workers whose skills have been made tion and technological changes, including but in what shareholders want from obsolete, whose prior human capital changes in distribution networks, are the companies, and how the companies are investment has been dissipated. It’s the main causes, and that it’s very difficult

30 Journal of Applied Corporate Finance • Volume 31 Number 3 Summer 2019 ROUNDTABLE to resolve these tensions at the level of a pharmacy tech, he or she doesn’t get a be pushing for and supporting this the firm, then I think you’re forced to tax subsidy on tuition and living expenses expansion of a government role are look for a government-orchestrated and incurred during the period of education. undermining government at every turn. maybe government-funded solution. We haven’t thought in a coherent way So I don’t know how you get us out about how to encourage folks to invest of that conundrum. In some ways you Alan Schwartz: Jeff, I had a couple of in themselves over the long period of have a system that works very well in questions. I think you’re right that their careers. theory, but not very well in practice. It’s employees bear more risk than they used a great theoretical model; but I don’t see to. In the safety literature, there’s some Steven Pearlstein: In a sense, you’re it happening in the United States. discussion of risk-adjusted wages. Could saying that we used to ask corporations risk-adjusted wages be used to reflect to balance all sorts of missions, some of Gordon: The claim I would make is that and compensate workers for the shift in which were private and generated large companies, acting in a rational way, self- risk bearing? My other question has to returns, and others which were social: interested way, would in fact favor greater do with acquiring human capital. My redistribution of income within the firm, government investment along the lines understanding is that adult retraining good deeds for society. You’re saying that that I’m suggesting. And that’s precisely programs tend to have low returns. Have now, in a vibrant, competitive global because the political frictions associated you given any thought to these programs marketplace, we can’t ask individual with the present system are becoming as part of the solution? firms to do that; and if we value these very intense. things like economic security or equal- Gordon: The evidence I’ve seen does not ity, we should let the public sector do that Pearlstein: But there’s no evidence that suggest that employee wages are, or have and let companies do what they do best, they behave that way rationally in the been, in a general way, risk-adjusted, and which is to be profit maximizers. political market. They, in fact, behave I suspect that’s in part because the risk That’s a nice theory. The problem is just the opposite way. They oppose every is hard to measure until it materializes. that, in a political economy sense, in the regulation, and every tax redistribution On the value of retraining programs, United States, the very forces that want of wealth. They oppose every increase in I think such programs are based on a to push profit maximizing also have spending on education. That’s the way pretty strong assumption about the plas- their hands on the testicles of the politi- the business community behaves in the ticity of human beings, and the potential cal system. And they prevent developing real world. I’m from Washington, and I for refocusing careers at different stages. the kind of regulation and social safety can tell you that’s true. The evidence coming from various U.S. net that you want the public to offer. pilot retraining programs is not so great, And much the same is going on in the Gordon: I don’t want to claim more than I but it’s also the case that the U.S. spends environmental arena. I’m guessing you know. All I’m offering is a way the world the least amount on retraining in the would say, don’t ask the companies to might well get better, not a prediction entire OECD. It makes me think we behave well environmentally; come up about the most likely path from here. If have yet to think very hard about how we with rules that force all companies to do the alternative is some other proposal, might make porting in and out of differ- the right thing. And if companies won’t which seems even less appealing to ent careers readily available, more readily do worker safety, we can and should have corporations—call it the Green New available than we do now. rules about worker safety. Deal—then my proposal, which calls for But I can think of one change worth So, it seems to me that you’re investment in human development over considering. Jon Macey says that the U.S. basically telling us to adopt a sort of a lifetime, all of a sudden seems like the system is incredibly biased in providing Northern European model, something moderate alternative. incentives for physical investment but like what they did in Denmark. They I wouldn’t presume to suggest a not investment in human capital. If a don’t ask companies to perform these political feasible path. My point is that, company installs a robot, under the 2017 social functions; they expect the govern- given the world in which we’re in, this tax act the company gets to expense it ment, the public sector, to do it. But is a plausible way forward—as opposed in the year of the investment. But if a in this country—and I can’t speak to to depending upon the induced kindness laid-off assembly line worker signs up England—everything’s been going the of companies and their managers, which for an educational program to become other way. The very forces that should seems to be the main alternative on offer.

Journal of Applied Corporate Finance • Volume 31 Number 3 Summer 2019 31 COLUMBIA LAW SCHOOL SYMPOSIUM Corporate Governance “Counter-Narratives”: On Corporate Purpose and Shareholder Value(s)

SESSION III: SECURITIES LAW IN TWENTY-FIRST CENTURY AMERICA: A CONVERSATION WITH SEC COMMISSIONER ROBERT JACKSON

Columbia Law School | New York City | March 1, 2019

Robert J. Jackson. Jr. John C. Coffee, Jr. Commissioner, U.S. Adolf A. Berle Professor of Securities and Exchange Law and Director, Center Commission on Corporate Governance, Columbia Law School

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Jack Coffee: Good afternoon, I’m with Lucian Bebchuk arguing that the that might slow him down, at least a Jack Coffee, and my job is to introduce poison pill is unconstitutional—and, can little. But I’m really going to let the and then lead a discussion with SEC you imagine, their position has yet to cat out of the bag by telling you—and Commissioner Robert Jackson. Rob has receive overwhelming acceptance from Rob will deny it, but his denials won’t been an SEC commissioner for one year, the courts.1 He may be about to tell us be credible—that he is shortly heading one month, and 18 days. Not a particu- what he’s going to do with the SEC to out to Iowa, where he’s meeting with larly memorable anniversary. But in that make the poison pill disappear from the community groups, local political short time, Rob’s blazed quite a trail and face of this earth—or he may tell us he’s leaders, and the citizenry—and maybe addressed a lot of issues that he alone reconsidered his position on the pill— we’ll see the waters tested. What is focused on and that, I think, deserve but I’ll leave that to him.2 you hear today might be a political exactly the attention he’s giving them. During his year, one month, and campaign in just a few more weeks Let me start, however, with the 18 days as Commissioner, he has boldly because, frankly, there are already 13 prosaic details. Rob is a summa cum expressed skepticism about whether candidates for the democratic nomina- laude graduate of Wharton, and later there is adequate competition among tion. But do any of those 13 have his received an MBA there in 2000. He also stock exchanges, and I think he has intelligence, his credentials, his ability? has a master’s in public administration some good evidence on that point. Even I find it hard to point to someone who’s from the Kennedy School and a JD from more broadly, Rob has really been first clearly ahead of him. Harvard Law School. Then he took a on the Commission to see potential So, having dug this little hole for research fellowship at Harvard. What all problems with the common ownership Rob, let’s see if he can dig his way back this evidence points out is that he would of public companies by a very limited out. Tell us what you’re going to do at do anything to avoid going to work. number of institutional investors. the Commission and elsewhere. But he eventually did go to work, And in this, he’s following some work practicing at Bear Stearns and then that’s been done by Einer Elhauge and Rob Jackson: Well, thank you very Wachtell, Lipton, where he specialized in John Coates at Harvard, and a bunch much, Jack, for that very kind—and executive compensation. After the 2008 of economists. That may be one of very dangerous— introduction. It’s so financial crisis, he went to Washing- the issues of the future. Jeff was just good to be back at Columbia, and to ton to work with Ken Feinberg at the suggesting the possibility of BlackRock see so many friends. I’m really very grate- U.S. Treasury, where he helped design and others lobbying Congress to fund ful to you and to the Millstein Center for the rules in the Dodd-Frank provisions programs to retrain laid-off workers. the opportunity to be here today. I want dealing with executive compensation. Well, there could be problems if such to begin just by saying how much I’ve If those rules had been adopted and large investors already have too much learned from the conversation so far, and implemented, we’d be in a much better power, if as few as 12 investors own a also how glad I am to be in a room with position; but for some reason, they didn’t majority of or exercise voting control so many important thinkers and policy- quite get all the way through Congress over our largest companies. makers. The people you’ve managed to and the administration. What lies ahead for Rob Jackson? gather here today are really at the cutting Then in 2010, tired of doing real Well, he’s getting married in June. And edge of the debates in corporate law. work, he retired to the Columbia Law I’m going to be brief. My plan is to

School faculty where, in 2012, he 1 See Lucian A. Bebchuk & Robert J. Jackson, Jr., speak for 10 or 15 minutes, and then I’d received the Willis Reese Prize for excel- Toward a Constitutional Review of the Poison Pill, 114 prefer just to take questions and have a Colum. L. Rev. 1549, 1550 (2014) (“We argue that the lence in teaching, which goes to only state-law rules governing poison pills are vulnerable to conversation—because it felt very much one person per year. The students said challenges based on preemption by the Williams Act.”). to me, standing at the back of the room he was the greatest thing they had seen. 2 Compare id. with Martijn Cremers, Robert J. Jack- for the last hour, that this is an ongoing son, Jr., & John Morley, The Value of Takeover Defenses: But though it sounds like I’m Evidence from Exogenous Shocks to Closed-End Mutual debate about some of the issues that giving a hagiography, Rob has not Funds (working paper, January 2015) (arguing, based on Colin raised in his book and that really event studies from a different context that “as takeover been completely successful at every- defenses became more legal, closed-end fund stock pric- deserve our attention at the policy level.3 thing he’s tried. I want to point to what es increased, and as takeover defenses became less legal, closed-end fund stock prices decreased. In other words, may be his leading failure, which he we find that in closed-end funds, shareholders like [] the 3 See Colin Mayer, Prosperity: Better Business Makes can still resurrect. He wrote an article poison pill.”). the Greater Good (2019).

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sking corporate boards of directors to make important stra- A tegic business decisions while considering the interests of all corporate stakeholders imposes a decision-making burden on the institution that we cannot and should not expect boards to carry. More- over, taking away companies’ clear, single-minded objective function of increasing long-run shareholder value raises real accountability problems. Without such an objective, what will guide boards when making the difficult tradeoffs among stakeholders that effective over- sight and management require? – Robert Jackson

There are three issues I want to talk everyone—and why I’m so committed other professors because they’re smarter about today that we’re facing at the SEC, to this theft, but the fundamental thing than me and have more intelligent views and that I really think are going to be to understand is that the conversations on the subject.”7 most important on our agenda in 2019. you’re having today are informing the Looking back at it, I think I was But these issues all relate to two themes way that folks like me are thinking about cheating. I think it was easier to teach that I want you to keep in mind as we what the future of securities law policy a world where we just do that one have this conversation over the next should be. I’m very proud of the fact that thing, and to encourage myself and my hour. a lot of what has come out of conversa- students not to worry about the impli- The first is that all good ideas that tions in rooms like this one has become cations for the rest of society. But it was I’ve ever had or will have, and that I’m or is becoming policy in the United not the right way to think about the trying to turn into policy at the SEC, I States securities markets. task I now face as a policymaker. I think have stolen from people here. I am an The second thought I’ll leave with what we’ve learned as a Nation in the last unabashed thief.4 I give footnotes and no you is that we should stop pretending decade or two is that those choices have more,5 and I have found that the ideas in as a Nation that the decisions we make significant implications, like the ones these conversations have been absolutely in our markets do not have significant Jeff Gordon was just talking about— invaluable to the policy conversations social implications. When I was a scholar the risks employees face working for we’re having in Washington. and a professor, I used to teach corpo- large public companies that are increas- I’ll talk a little bit about whom I’ve rate law just across hall here at Columbia ingly being pushed to earn profits at stolen from in this room—it’s basically Law School. On the first or second day, I almost any cost.8 And this means that would say, “For purposes of this course, we need to think seriously about the 4 Compare, for example, Commissioner Robert J. we’re going to do the following exercise. social bargain we have struck between Jackson, Jr., The Middle-Market IPO Tax (remarks at the Ohio State University Greater Cleveland Middle Market We are going to maximize what I refer Forum, April 2018) (citing Hsuan-Chi Chen & Jay R. Rit- to as Kaldor-Hicks efficiency.6 We’re 7 See, e.g., Columbia Law School, Faculty Profiles: ter, The Seven Percent Solution, 55 J. Fin. 1105 (2000)) Gillian Metzger (citing Foreword, 1930s Redux: The Ad- with Commissioner Robert J. Jackson, Jr., Perpetual going to just maximize the size of our ministrative State Under Siege, 131 Harv. L. Rev. 1 Dual-Class Stock: The Case Against Corporate Royalty economic pie, and all these other social (2017)); Columbia Law School, Faculty Profiles: Alex (remarks at the Berkeley Law Symposium in San Fran- questions we’re going to leave for your Raskolnikov (citing Accepting the Limits of Tax Law and cisco, California, January 2018) (citing Martijn Cremers, Economics, 98 Cornell L. Rev. 523 (2013)); Columbia Beni Lauterbach & Anete Pajuste, The Life Cycle of Dual- Law School, Faculty Profiles: Jessica Bulman-Pozen (cit- Class Firms (working paper, January 2018)) and Com- ing From Sovereignty and Process to Administration and missioner Robert J. Jackson, Jr., Stock Buybacks and 6 That idea was even less original to me than most of Politics: The Afterlife of American Federalism, 123 Yale Corporate Cashouts (remarks at the Center for American my policy proposals. See, e.g., Frank H. Easterbrook & L.J. 1920 (2014)). Progress, June 2018) (citing Jesse M. Fried, Insider Trad- Daniel R. Fischel, The Economic Structure of Corporate 8 See Jeffrey N. Gordon, Addressing Economic Inse- ing via the Corporation, 162 U. Pa. L. Rev. 801, 805 Law 11-12 (1991); see also Milton Friedman, The Social curity: Why Social Insurance Is Better Than Corporate (2014)). Responsibility of Business is to Increase Its Profits, N.Y. Governance Reform, Columbia Law School Blue Sky Blog 5 See supra note 4. Times Mag. (Sept. 13, 1970). (August 21, 2019).

34 Journal of Applied Corporate Finance • Volume 31 Number 3 Summer 2019 ROUNDTABLE those companies, their consumers, their here, I just let Merritt handle the compli- Now, if I were still an academic and employees, and their investors; we need cated stuff. But what I have learned in you asked me whether that was a good to think about what our expectations Government is that the bargain secu- thing, I might respond, “If price discov- are for the large investment funds that rities regulators struck with our stock ery is the goal, it may well be.”15 But I hold the savings and futures of millions exchanges 15 years ago has fundamen- have since learned that the pursuit of of American families. tally changed our markets, and in a way price discovery in this fashion has very I think we can no longer pretend that I don’t think is fully appreciated and real costs. One manifestation of those that there is such a thing as socially that has real implications for American costs can be seen by noting that we have neutral corporate or securities law policy investors and public companies. 13 public, or “lit,” stock exchanges in in that respect. The decision to do or not You all know the history of the the United States. We’ve got 13 differ- to do something in that area is funda- stock exchanges. They used to be ent venues to which an order that you mentally a social decision.9 We should collectively controlled and owned by place for shares can be delivered; and accept and embrace that fact and have most of Wall Street, pursuant to the of those 13, 12 are owned by just three the appropriate conversation—instead famous Buttonwood agreement.11 conglomerates. of pretending there’s a way intellectually Over the years the markets evolved in I was in a prior life a legal and finan- to avoid that part of the conversation, a fashion that called for new rules, and cial advisor on mergers and acquisitions, because it’s too hard. the Commission eventually enacted and my first reaction to learning this was, So that’s my basic proposition. And what is now known as Regulation “That sounds like a weird M&A strat- I have three policy areas I’d like to talk NMS.12 Those rules were intended to egy: Let’s buy all the units that do mostly to you about that, in my view, illustrate protect investors and make sure they the same thing, and then just have them why economic choices are at bottom got the best price when they dealt on compete against each other.”16 No choices about what kind of society we the stock exchange. In many ways, the CEO in a competitive industry would want to live in. These are things that I rules have helped achieve just that.13 pursue that strategy. Why do the stock now understand in a different way than But what followed was an incredible exchanges? One answer might be that I did when I taught across the hall. Then decade-long arms race in which investors the law encourages that outcome by I’ll wrap up and we can have a conversa- paid millions of dollars for high-speed permitting them to charge connection tion about how to move policy forward trading to address what is now known as and access fees that investors pay for on in these and other areas. “latency arbitrage.”14 It’s hard to overes- a per-exchange basis. timate the amount of capital that has Now we can debate whether that’s The State of American Stock been invested in technology, lobbying, a good thing or a bad thing, but what Exchanges and legal fees to create and protect that astonished me when I arrived at the So first let’s talk about American stock franchise. SEC is that for years the exchanges had exchanges. The history of U.S. stock managed to extract those costs from exchanges is one that I hadn’t spent a lot sten, & Gabriel Rauterberg, The New Stock Market: Sense American investors with very little public of time on—even though my Columbia and Nonsense, 65 Duke L.J. 191 (2015). debate. That struck me both as an aston- 11 See, e.g., Commissioner Kara M. Stein, Remarks Law colleague, Merritt Fox, has written Before Trader Forum 2014 Equity Trading Summit (New ishing feat of lobbying, and something some of the world’s leading scholarship York City, February 2014) (describing this history). very troubling for American investors.17 12 Securities and Exchange Commission, Concept Re- on the subject, and I commend it to lease on Equity Market Structure, Exch. Act. Rel. No. 34- you.10 When I was on the law faculty 61358, 75 Fed. Reg. 3594 (Jan. 21, 2010) (describing 15 See Fox, Glosten, & Rauterberg, supra note 10, at the genesis of Regulation National Market System and the 207 (making a similar argument). market-driven innovation that followed its adoption). 16 See, e.g., McKinsey & Company, McKinsey Quar- 9 For a closer examination of this argument, published 13 See id.; see also Fox, Glosten & Rauterberg, supra terly: Six Successful M&A Strategies (Spring 2017) (not- before I took office at the Commission,see, e.g., Lucian A. note 10, at 204 (describing extensive benefits to investors ing the common strategy to “[c]onsolidate to remove ex- Bebchuk & Robert J. Jackson, Jr., Shining Light on Cor- derived from the market structure that emerged from this cess capacity from industry,” but making no mention of porate Political Spending, 101 Geo. L.J. 923, 964 period). acquiring and operating competing franchises in the same (2013) (“[T]he SEC should not be deterred from acting to 14 For an engaging description of one example of this industry). provide investors with information they need by the pos- kind of arbitrage, see Michael Lewis, Flash Boys : A Wall 17 I made this argument most forcefully in public re- sibility that its actions might have implications for the Street Revolt (2015); for a more recent analysis of the marks at George Mason University in September 2018, political landscape.”). prevalence of this kind of trading, I commend the insight- see Commissioner Robert J. Jackson, Jr., Unfair Ex- 10 See, e.g., Merritt Fox, Lawrence R. Glosten, & Ga- ful analysis in Robert P. Bartlett & Justin McCrary, How change: The State of America’s Stock Markets (Sept. 19, briel Rauterberg, The Economic and Legal Structure of Rigged Are Stock Markets? Evidence from Microsecond 2018), shortly before the Commission took several steps the Stock Market (2019); Merritt Fox, Lawrence R. Glo- Timestamps, J. Fin. Mkts. (forthcoming 2019). related to those policy questions, see, e.g., Rob Daly, SEC

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When I have this conversation with conversation that we need to have as a a really excellent thief. When I testified people, they say, “This sounds really Nation, and I’m proud to be a part of it. on this subject, I based my testimony technical, and not very interesting from largely on a tremendous paper by John a social point of view.” My point to you Concentration of Corporate Coates at Harvard, who explains why it’s today is that that’s wrong. When you talk Ownership possible to imagine a corporate world in to an ordinary American investor—and Second, I want to talk a little bit about which a dozen or fewer individuals have part of my job is to talk with retail inves- the role of institutional investors. There’s that kind of control over our economic tors across the United States—and you a broad public conversation we’re having destiny.23 try to explain to them why there are 13 right now about the degree to which The reason that’s important to stock exchanges, and why 12 of them are common ownership of public companies understand is the same reason that Chief owned by three conglomerates, they get is affecting competition in this country.20 Justice Leo Strine, who’s here today, has the sense that this is yet another way in My own view, with great respect to pointed out: namely, to the degree you which the financial system is designed the exceptional scholars in this field, is feel that corporate America has let you to profit somebody else at their expense. that that conversation is important but down and done something that isn’t I’m very proud of the SEC’s work in this misdirected. As I explained in recent fair—like spending dark money on respect; for the first time in two decades, testimony before the Federal Trade politics—it’s time to call to account the we have gotten very serious about Commission, this issue strikes me as a institutional investors who sat silently by examining these issues. I gave a speech on challenge not of market competition but while that happened.24 So I think Leo’s the subject at George Mason University of corporate governance.21 right about this; it won’t do to blame back in September and have been joined I say that because of the astonishing corporations by themselves on this issue. by my colleagues on a number of policy and understudied role that these institu- I think we’ve got to be candid and initiatives that I’m very proud of. These tions play in the outcomes of corporate look large institutional investors squarely initiatives are all bipartisan and have been elections.22 This is an enormously impor- in the eye and say, “You guys have unanimously adopted at the SEC.18 tant task that we’ve charged institutional overseen this; where have you been?” We’ll soon hopefully have a transac- investors with. Corporate lawyers in the As a society, in the public conversations tion fee pilot in which we test the effects room who advise boards will tell you we’ve had about corporate America, we of certain payments that the exchanges that most contested questions in corpo- really like to blame corporations. It’s make to attract volume.19 I’m happy rate America today are decided by just a really great to have somebody to point to to talk more about the details, but for few large funds. Persuade them, and you and say, “It’s your fault.” But everyone in now I just want to say that taking on carry the day. this room knows that assigning respon- that subject—the notion that our stock Now, again I’m not prepared to say sibility for today’s economic and social exchanges have concentrated power that this is necessarily a good or a bad problems is a much more complicated that they use to extract excess fees from thing. It’s just something that deserves task than blaming corporate America American investors—is an important our attention. And as I said early on, I’m alone. Companies have a broad range of constituencies, and we all bear responsi-

Rules for SIFMA in Market Data Case, Markets Media 20 See, e.g., Jose Azar, Martin C. Schmalz, & Isabel bility for where we are as a Nation. (Oct. 16, 2018) (“The U.S. Securities and Exchange Tecu, Anticompetitive Effects of Common Ownership, 73 Commission has set aside [exchanges’ requests to ap- J. Fin. 1513 (2018); see also Einer Elhauge, Horizontal prove certain] depth-of-book fees.”); see also U.S. Secu- Shareholding, 129 Harv. L. Rev. 1267 (2016); Eric Pos- 23 See John C. Coates, The Future of Corporate Gov- rities and Exchange Commission, SEC Adopts Transac- ner, Fiona Scott Morton & E. Glen Weyl, A Proposal to ernance Part I: The Problem of Twelve (working paper, tion Fee Pilot for NMS Stocks (Dec. 19, 2018). Limit the Anticompetitive Power of Institutional Inves- Sept. 2018) (“In effect, indexation is concentrating power 18 See supra note 17; see also Joint Concurring tors, 81 Antitrust L.J. (2019). over all public companies in the hands of one [small] Statement of Commissioners Hester Peirce and Elad Ro- 21 See Commissioner Robert J. Jackson, Jr., Common group.”). isman Regarding Application of SIFMA for Review of Ac- Ownership: The Investor Protection Challenge of the 21st 24 See Chief Justice Leo E. Strine, Jr., Fiduciary Blind tion Taken by NYSE Arca, Inc. and NASDAQ Stock Mar- Century, testimony before the Federal Trade Commission Spot: The Failure of Institutional Investors to Prevent the ket LLC (Oct. 16, 2018) (noting my colleagues’ Hearing on Competition and Consumer Protection (Dec. Illegitimate Use of Working Americans’ Savings for Cor- thoughtful “vote[] to support this decision” while 6, 2018). porate Political Spending, New York University School of “rais[ing] a critical policy question underlying these pro- 22 For an important and early examination of the joint Law Distinguished Jurist Lecture (Nov. 29, 2018); see ceedings”). role of large institutional investors and activists in contem- also Leo E. Strine, Jr. & Antonio Weiss, Why Isn’t Your 19 The pilot study described supra at note 17 is cur- porary corporate governance, see Ronald J. Gilson & Jef- Mutual Fund Sticking Up for You?, N.Y. Times (Aug. 23, rently subject to litigation; exchanges have sued in the frey N. Gordon, The Agency Costs of Agency Capitalism: 2019) (“[C]orporate governance reform will be effective D.C. Circuit to block the Commission’s study of these Activist Investors and the Revaluation of Governance only if institutional investors use their voting power prop- matters. Rights, 113 Colum. L. Rev. 44 (2011). erly.”).

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That’s why, when I’ve talked about environmental future, or to ending of the obligations of all the constituents this subject both publicly and privately inequality. They don’t have the author- of the corporation; the investors, the at the SEC, I’ve pushed people to answer ity or knowledge or resources to solve board, and those who represent them. In those questions in a way I could explain those problems. other words, I think we want to under- to an ordinary American investor. Trying And expecting them to do that is stand the responsibilities of being a large to explain to them why corporations a prescription for profound unhappi- institutional investor in this world better participate in politics to the extent they ness for millions of families who rightly than we do today. do, and why they make the choices they feel let down by modern corporations. Let me give you an example of what do about executive compensation, is not Moreover, taking away companies’ I mean. For those of you who are inter- easy. Explaining why large institutions clear, single-minded objective function ested in this subject, are you confident vote ordinary investors’ shares in favor of increasing long-run shareholder value that we understand the degree to which of spending American families’ money raises real accountability problems. large institutional investors actually this way is even harder. It’s time to ask Without such an objective, what will vote in a way that reflects the prefer- ourselves whether the fact that we can’t guide boards when making the difficult ences of the underlying investors whose explain these things to ordinary investors tradeoffs among stakeholders that effec- money they’re voting? Do you feel we tells us something important about the tive oversight and management require? have a good empirical understanding of state of corporate America. I worry that, without an obvious goal to the degree to which large institutional pursue, we’ll end up feeling that boards investors vote their shares in the way Stakeholder Theory and the Law have failed both investors and stake- the ordinary underlying retail investor Third, I want to talk about the funda- holders. would want them to? mental idea that the solution to part of And that’s why I think Chief I don’t think we know that. And I our social problems might be to allow Justice Strine is so right to point to think we should, because as Chief Justice corporations to consider the interests of the responsibility of other corpo- Strine and others have pointed out, if constituencies other than their share- rate constituents for some of today’s we’re really going to have a conversa- holders when they make major business problems.26 Even if we’re worried about tion about what we want corporations decisions. The notion that you might the degree to which corporations do or to achieve and what investors want from have a wise council of individuals who do not take those kinds of consider- them, then we should understand the will consider all these things and come ations into account, it does not follow way underlying investors think about up with the right answer and solve that we should adopt a rule that invites those issues and whether or not the these problems for us is a very tempt- managements and boards to consider votes that are getting cast reflect those ing idea.25 other stakeholders in major strategic interests. That, to me, is part of the But I’m unconvinced. The reason is and business decisions. The dangers intellectual enterprise of understanding that asking boards of directors to make of this kind of managerialist approach what we’re asking corporations to do and such important decisions while consider- are clear, as Jeff Gordon just told us, why. The fact that we haven’t explored ing all these different interests imposes to anyone who’s studied the corporate it strikes me as a notable and actually a decision-making burden on the insti- conglomerates of the last century.27 telling omission. It makes me wonder tution that we cannot and should not What I think we should do instead whether the question we’re really asking expect boards to carry. Look, I’ve been is ask whether addressing social and is whether corporations are doing what in those boardrooms. They’re filled with environmental problems should be part their individual shareholders want them good people who are trying to do the to do, or whether we’re really playing right thing. But the fact is that corpo- 26 See Strine, supra note 24 (asserting that institu- a different game. rate boards do not hold the keys to our tional investors should be held to account for the degree So my request for all of you would to which corporate resources are used in a fashion incon- sistent with ordinary investor interests). be to begin those conversations today. 25 See, e.g., Business Roundtable, Statement on the 27 The claim that corporate law should defer to mana- And the goal here is not just to come Purpose of the Corporation (Aug. 19, 2019) (purporting to gerialist judgments about the needs of certain “constituen- “redefin[e] the purpose of the corporation to promote an cies” should be familiar to any serious student of corpo- away with an answer to the decades-old economy that serves all Americans”); see also Plato: Five rate law. George Santayana, The Life of Reason: The question about whether boards should Dialogues (2d ed. 2002) (providing the seminal thesis Phases of Human Progress Volume 1, Reason in Com- that “philosopher kings” might be the best trustees of a mon Sense (“Those who cannot remember the past are be able to consider interests other than society’s future). condemned to repeat it.”). investors’ when making important

Journal of Applied Corporate Finance • Volume 31 Number 3 Summer 2019 37 ROUNDTABLE decisions. Yes, that’s important, and back and forth. And, as Rob has argued, the explanation has to do with price I’m happy to keep having that conver- that looks anticompetitive. discovery, which we all know is socially sation. But we also want to explore In any event, that’s the backdrop. valuable. But I also think there are more generally whether we should set Now, as Rob also mentioned, Columbia needless costs associated with having this before corporations alone the task of Law’s Merritt Fox is one of the world’s structure. More fundamentally, I think solving our broadest social problems. leading experts in this area. Merritt, what we need to think about whether our If we’re going to do that, shouldn’t we do you think about Rob’s argument? system for trading stocks is the best we be asking the same thing of the largest can do for ordinary American investors. institutional investors in America, and Fox: I think Rob’s right that there’s the I’m not convinced that the answer is yes. be prepared to hold them responsible for potential for anticompetitive problems the choices they’ve made over the last 30 with the industrial organization of the Jim Millstein: Rob, we now have esti- years that have brought us to the place trading industry. On the other hand, mates that 50% of stock trading volume we’re in as a Nation? we are also seeing trading costs that is going on in dark pools. What’s your And now let’s have a conversation. are much lower than they’ve ever been reaction to the impact of the structure Thanks so much for having me and for before. Now maybe we could do even of public exchanges on that increasing having this important conversation. Tell better, but the significant reduction in trend? me what’s on your mind. And tell me spreads and commissions—and thus in what you’ve learned today about the the total costs borne by people making Jackson: Before I answer, let me say I most pressing policy issues before the trades—have all gone down over the had the very great privilege of having Commission. past ten years. And that makes me ques- Jim as my boss, when he was the chief tion whether there’s really a problem. restructuring officer of the Treasury Discussion with the Department.28 For a long time Jim Columbia Audience Jackson: Let me say two things about was the only thing standing between Coffee: As you heard, Rob just gave us that. First, there’s no better place to hide AIG and a Nation in total catastrophe. three big topics he wanted to discuss. rents than in markets with falling prices, He was astonishingly successful in The first was competition among because we don’t know the counterfac- restructuring AIG while preserving its stock exchanges. The next was insti- tual—that is, what costs would have value in incredibly difficult operational tutional investors, and the potential been in a more competitive landscape, and political circumstances. Far too dangers of consolidation. The third is what the costs would have been other- few Americans know this, but thanks the degree to which boards and others wise. The question is, how fast should to Jim, taxpayers earned more than $5 should be able to take account of those prices be falling? billion on their investment in AIG.29 ESG—environmental, social, and gover- But put that completely to one side. But back to Jim’s question. First of nance—considerations in their strategic I want to propose that just having the all, as Merritt has taught me over the and operating decisions. structure we do—that is, having the years, dark pools tend to provide price Let’s take these one at a time. I’m deepest, most liquid capital markets improvement to investors at the margin. going to ask for questions first on the in the world structured in a fashion So there’s an argument that investors do stock exchange issue. As you will recall, that makes little theoretical economic a little better by dark pools. But that Rob has said that of the 13 public sense is, by itself, costly. The idea that stock exchanges, 12 are owned by three our stock exchanges are set up to send 28 See, e.g., Barry Ritholtz, Jim Millstein and the Re- entities. By the way, those three owners orders around New Jersey to maximize structuring of AIG, The Big Picture (Oct. 28, 2018) (de- are NASDAQ, ICE, and the CBOE. private profits—the fact that funds scribing Mr. Millstein’s crucial role in restructuring the He also makes the point that generally, exist for no other purpose than to trade company during the United States Treasury’s exceptional rescue of the firm); Serena Ng, Treasury Restructuring when companies acquire lots of other stocks at breathtaking speed—these are Chief to Exit, Wall St. J. (Feb. 24, 2011) (describing Mr. companies, they typically consoli- hard things for us to explain to people Millstein’s successful conclusion of his work just two years into his appointment). date their operations. But this hasn’t who are wondering why they can’t make 29 See United States Department of the Treasury, In- happened in the stock exchange indus- their rent. And it’s a challenging thing to vestment in American International Group (AIG) (Dec. 9, 2013) (noting that, following Treasury’s sale of AIG com- try, perhaps because the exchanges seem explain to American investors. mon stock in a 2012 public offering, taxpayers’ return on to love charging fees for sending orders Now I understand that part of their investment in the company exceeded $5 billion).

38 Journal of Applied Corporate Finance • Volume 31 Number 3 Summer 2019 ROUNDTABLE said, I do have a concern. Dark pools the SEC to really think about encourag- I think what I’ve become persuaded of have sucked so much volume off the ing that type of innovation in the system by Trevor and others in the space is that exchanges that I worry about the degree and not preventing some of the really the securities law we have is a choice to which the price discovery we get on good ideas from being crushed at the about the role those people should play the exchanges is correct. I worry about beginning because they just realize it’s in the agenda setting and investments this especially at the close of trading.30 going to be too damn expensive for us in American society. What you’ve been What the exchanges tell me is that to get through that process? pushing me to do is to ask myself if that’s not a critical concern yet, but that’s the right choice for the Nation. that we could easily end up in a place Jackson: Doug, you’re absolutely right That’s the view I’ve come to, having where it would be. That would be one about this. We aren’t creating the kinds been in this job for a little while—and of the things we’d have to figure out if of incentives we need for people to create that’s really the question I should have we’re going to do something different on new technologies that can compete on been asking myself all along. exchange regulation. And just to be clear, the margin. But that said, you’re also although I’ve been hard on the exchanges right to say that they’ve created the Costs of Common Ownership today and in the past, they provide a very system they did because it’s within the Coffee: I’d like to move on now to the valuable service in terms of that price rules we set up, and it maximizes their second topic, which is common owner- discovery, especially at the close. That’s profits under those rules. I try hard in ship. As I indicated in my introduction, something we need to preserve. life not to get angry at people for follow- and as you confirmed, you’ve been read- ing the incentives we give them. The ing a lot the work of John Coates and Doug Chia: I’m Doug Chia from the problem in such cases is really not the others. They’ve been arguing that, as Conference Board. In your comments on people; it’s the incentives. This is my we see great consolidation among insti- the monopoly of stock exchanges and the problem, not theirs. That’s why I’ve been tutional investors, there’s the chance rents they extract from all of us, it seems proud to be a part of looking carefully at they’ll get together and agree on anti- to me that what has to happen—and those regulatory incentives. competitive behavior. probably will happen at some point— If you take one thing away from my John Coates has been putting more is for some kind of disruptor to come talk, this is the idea that I want to share emphasis on the political impact. We’ve into that industry. Just as we’ve seen in with you. When we make that kind of heard that 12 people or fewer can influ- so many industries today, an Uber or a choice, it may feel narrow; it may feel ence corporate elections, but Jeff Gordon Netflix just comes in and changes the small. But it isn’t; it’s a choice about the wants them to influence Congress as game entirely. So much of that—when kind of system we want to have, the kind well, and that gives me pause if 12 people it happens—is about disintermediation. of market we want to have, the kind of can push that heavily. So against that In order for that to happen, there country we want to have. backdrop, what questions do we have has to be new technology; and there also I’ll give you another example. about the role of institutional investors? typically has to be changes in the regula- Another former boss of mine, Trevor tions. The stock exchanges are the way Norwitz from Wachtell, Lipton, often Eric Orts: I’m Eric Orts from the Whar- they are today and don’t have a lot of comes to these events; in fact I think I ton School, and I’m really happy to competition because they’re regulated by see him now. He raises his hand, and he hear about really great people who have the SEC. You do have attempts to come says, “You have to do something about high grades from the Wharton School up with alternatives from time to time, activist investors; they’re a parasite upon making such a huge public statement. but they have to go through this regula- the Nation.” My question has to do with finance. tory vetting process. All that said, does it make sense for Trevor Norwitz: The word I like to use Jack: Well, excuse me. If you feel that is “scourge.” way, are you going to publish Jackson’s grades? 30 In August 2019, trading issues did develop near the market close, although the effects of those issues on ordi- Jackson: Ok, “scourge.” And I say, nary investors are not yet known. See, e.g., Yun Li, A “Well Trevor, you know, it’s compli- Eric: No. [Laughter.] Anyway—so my Trading Issue Impacted US Stock Quotes Late in the Day as Dow Flatlined Into the Close, CNBC Markets (Aug. 12, cated. The agency costs associated with question has to do with the increasing 2019). corporate managers can be significant.” power of the financial services industry

Journal of Applied Corporate Finance • Volume 31 Number 3 Summer 2019 39 ROUNDTABLE in terms of its lobbying clout. I think we petitioned the Commission to take up enon that has existed since I was a know that finance is the highest lobby- rules requiring transparency of the kind banker: namely, when a banker brings ing group, and there’s increasing concern Eric is asking about, my co-signers on a company public, and that company is about the influence of finance over our that petition included Jack Coffee, Jeff worth less than $1 billion, 97% of the political system. In the 1950s, finance Gordon, Ron Gilson, and others in the time the banker charges a 7% spread— was just 2% of GDP. In 2008, it was room.33 We urged the SEC to make not 6½%, not 7½%, but exactly 7%.35 8% or 9%.31 rules that would require more trans- I called it a “tax” and said that it’s So my question is about the concen- parency in this respect. And some 1.2 hard to understand why that price is still tration of the financial services industry. million people have since written to the the same as it was when I was a banker. What is the SEC doing to curtail the SEC to urge them to adopt those rules. It was a very different time. It was dialup influence or at least making public But, we can’t do it right now; and internet. I was one of the guys who was disclosure of what the finance industry the reason is that Congress passed a law taking companies public during the is doing politically? A long time ago, saying we can’t. There’s an appropria- dot-com boom. But Wall Street has lobbying was even illegal. If there’s really tions bill that says that we can’t spend provided no price improvement to small the public interest that’s at stake here, any money to finalize a rule in that IPOs. And I have to ask whether or not should the SEC take some more forceful respect.34 But I think it’s something the concentration we see in the industry approach on this? that we should be considering when the is a driver of that. And, finally, I think we need to law permits, and for the reasons that So, one of the things I’ve been figure out what kinds of investors we’re you’ve given. trying to do in office is to shine light on really regulating for. When I raised the Now, what about your question concentration in the markets we oversee idea of retail investors in an MBA class about the concentration that we see and what the SEC can and should do recently, someone put up their hand and in the financial services industry, and about it. And I’ve gotten this very said, “The whole idea of a small inves- its costs for ordinary Americans? At a strange reaction, which is that compe- tor these days is a joke. It doesn’t really minimum, I’ve said that we should be tition simply isn’t in the SEC’s ambit. exist.” So, maybe we should get away pushing industry to explain and account Now, reasonable people can and should from that model of who we’re trying to for the possible costs of that concen- disagree about policy in this area. But protect. tration. In one of my first speeches as the claim that it’s outside the SEC’s an SEC commissioner, stealing again jurisdiction is just wrong. Jackson: Let me get back to the small from academia, I pointed to a phenom- In a talk I gave a little while investor point in a moment. Let’s talk ago to the Open Markets Institute, first about the first question you asked, Rev. 83 (2010). I documented the history of the SEC’s Eric, because it’s a good one. You asked: 33 See Committee on Disclosure of Corporate Political work regarding competition.36 As I Should the SEC be doing more to Spending, Petition for Rulemaking to Require Disclosure pointed out there, when the securi- of Corporate Political Spending to Public-Company provide transparency with respect to Shareholders (Aug. 3, 2011). Professor Jackson was a ties laws were first enacted, there was the effects of this lobbying? The answer principal draftsman of the petition, which has since been no Securities and Exchange Commis- the subject of more than 1.2 million comments urging to that question is clearly yes. And I’ve the Commission to take action—more than any proposal sion. The ’33 Act, when first passed, been advocating forcefully for that. in the Commission’s history. See Securities and Ex- charged the Federal Trade Commission change Commission, Comments on Rulemaking: Petition When I first joined the Colum- to Require Public Companies to Disclose to Shareholders with oversight of the securities laws.37 bia faculty, I published an article with the Use of Corporate Resources for Political Activities, It wasn’t until Joe Kennedy persuaded File No. 4-637; see also Letter of Former SEC Chairman Lucian Bebchuk in the Harvard Law William Donaldson, Former Chairman Arthur Levitt, and Review on that subject.32 When we later former Commissioner Bevis Longstreth to Mary Jo White, 35 Commissioner Robert J. Jackson, Jr., The Middle- Chair, SEC (May 27, 2015) (bipartisan letter of former Market IPO Tax (remarks at the Ohio State University high-ranking Commission officials referring to the peti- Greater Cleveland Middle Market Forum, April 2018) 31 See, e.g., United States Bureau of Economic tion’s proposal as a “‘slam dunk’ for the Commission”). (citing Hsuan-Chi Chen & Jay R. Ritter, The Seven Per- Analysis, Gross Domestic Product by Industry (July 19, 34 See, e.g., Ning Chiu, Spending Bill Prohibits SEC cent Solution, 55 J. Fin. 1105 (2000)). 2019) (providing an industry-by-industry breakdown of from Any Political Contributions Disclosure Rulemaking, 36 Commissioner Robert J. Jackson, Jr., Competition: contributions to gross domestic product, and noting that, Davis Polk Briefing: Governance (May 3, 2017) (“Similar The Forgotten Fourth Pillar of the SEC’s Mission (re- in the first quarter of 2019, the finance and insurance to prior appropriations bills, the proposal continues to marks at the Open Markets Institute, Oct. 11, 2018). industry added significantly to growth in GDP). prohibit the SEC from using any funds to issue rules or 37 See id. (citing Letter of Harvard Law School Pro- 32 See Lucian A. Bebchuk & Robert J. Jackson, Jr., regulations regarding the disclosure of political contribu- fessor Felix Frankfurter to Franklin D. Roosevelt, Presi- Corporate Political Speech: Who Decides?, 124 Harv. L. tions.”). dent of the United States (May 23, 1934).

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FDR that we needed a separate agency asset manager don’t really reflect what be a huge cost to that, because the fund that the ’34 Act was passed, and that their shareholders want. I want to take may well sacrifice returns to achieve its the SEC was created. Even back then, a pretty aggressive position on that. The social goals. when the birthplace of the SEC was in answer is, nobody’s got a clue. But it’s But let’s go back to the broader the FTC, a competition agency, it was worse than that. Given the way shares question Jack was raising: how and thought that competition was essential are held these days, it would be easier to when do we want those votes to count? to the agency’s mission. figure out whether Al Gore won Florida The complexity of the restructuring and How do I know that? Because the than find out who the beneficial owners the privacy issues associated with getting statutes that empower us to make rules are; there are so many layers of interme- the funds access to those shareholders require examination of concentration diaries that, for most of the companies, are complex and troubling. And the first when we make them—though we most of the fund managers don’t know step in this process may be figuring out ordinarily don’t do it.38 I’ve been trying who their shareholders are—let alone what it is we want those votes to do. to move the agency in that direction what they think. It would make the to fulfill our statutory mandate, but CDOs during the financial crisis look Jackson: I was making a slightly differ- also to grapple with the reality we face, transparent. So my point is simply not ent point, which is just the very basic which is that the rules we adopt have that it wouldn’t be a really great idea first step of knowing what votes were the effect of concentrating power in to know, but without a major kind of counted in a contested election. Given this country, and we should be held restructuring that isn’t feasible, I don’t that people are rationally apathetic accountable for that.39 think it’s knowable. about casting their votes, it’s hard to see why we should impose the additional Coffee: You got us into the topic of Jackson: So that’s a good point that cost of them not even knowing whether investment bankers and common fees Ron’s making, and it’s consistent with a their vote will be counted in a close case. and limited competition, but the area statement I issued a few months ago on To me it’s very important that the that people talk about most is the grow- corporate voting.40 That system is such SEC step forward and take a position ing concentration among institutional a complete mess that it’s very hard to on this. I’ve advocated that if an inves- investors. Three of them in particu- even think about what the answer might tor wants to know whether their vote in lar—Vanguard, BlackRock, and State be. At an SEC roundtable six months a corporate election was counted, they Street—now account for about 20% ago, after watching the P&G proxy can get an answer to that question. And of the stock of all publicly held corpo- contest, I said that if an ordinary Amer- I’m actually very optimistic that the SEC rations. What does that mean for ican investor wants to know if his vote will take that step. corporate governance and the issues was counted in the election in which he we’ve been discussing today? voted, he’s not legally entitled to get that Coffee: So, you’ve touched on the ques- answer. That’s an astonishing thing. And tion about what ballots count. Another Ron Gilson: What I actually wanted to I hope we’ll soon fix that at the SEC. question that’s hiding behind that is comment on—but I’ll talk about that as whether the middle managers at mutual well—is Rob’s suggestion that the votes Gilson: The problem I’m talking about funds who actually vote the shares are cast by institutional investors and their is slightly different. For investors who voting the way the ultimate owners want, care about how their votes get cast, or the way the CEO or companies would 38 See id. n. 17 (“All four [of the Commission’s en- their best bet is probably to find special prefer. In cases where asset managers abling] Acts contain the following language: ‘Whenever … the Commission is engaged in rulemaking and is re- purpose funds. But there’s also likely to stand to gain from access to CEOs and quired to consider or determine whether an action is nec- senior management, the managers are essary or appropriate in the public interest, the Commis- likely to vote shares in favor of compa- sion shall also consider, in addition to the protection of 40 See Commissioner Robert J. Jackson, Jr., State- investors, whether the action will promote efficiency, ment on Shareholder Voting (Sept. 14, 2018) (“[T]here nies even when their shareholders might competition, and capital formation.’” (citing 15 U.S.C. is broad agreement that the Byzantine system that makes prefer otherwise. That brings us back to §§ 77b(b), 77b(f), 80a-2(c), 80b-2(c))). it impossible to know whether investors’ votes are being 39 See, e.g., Commissioner Robert J. Jackson, Jr., counted must be fixed.” (citing Marcel Kahan & Edward the old debate about short-term versus Dissenting Statement on Proxy-Advisor Guidance (Aug. B. Rock, The Hanging Chads of Corporate Voting, 96 long-term, because if you’re compensated 21, 2019) (“[B]ecause we have not more deeply exam- Geo. L.J. 1227 (2008) and David A. Katz, Wachtell, Lip- ined the implications of today’s guidance for competition ton, Rosen & Katz, Proxy Plumbing Fixes Are Desper- on the short-term rise in the portfolio as in corporate voting, I respectfully dissent.”). ately Needed (Aug. 31, 2010)). a middle manager, you may look at what

Journal of Applied Corporate Finance • Volume 31 Number 3 Summer 2019 41 ROUNDTABLE short-term stock prices are going to do. buybacks, a subject that’s gotten a lot of ultimate beneficiary of their fiduciary So, how do we determine whether or not attention. It’s very clear in the data that duties to be shareholders, or the other middle managers’ votes follow anything on the day executives announce stock stakeholders as well. other than the expected effect on their buybacks, they engage in more stock compensation? sales on that day than any other day, Jackson: That’s a good question, something like three times as much. I Cynthia. In fact, Jill Fisch, who’s here Jackson: That’s a great point. I think said that this practice is worthy of atten- today, signed an ESG petition not long one of the hardest things for me to tion, because it gives managers incentives ago that I was very impressed by. see in my new job is how little change to do stock buybacks—whether or not there has been in the incentives of those are long-run beneficial for the Jill Fisch: Cynthia wrote that petition. senior managers with respect to short- firm—because they can cash out their term versus long-term stock prices. shares today. Jackson: I didn’t know that! It’s a great The world’s leading scholar on execu- Jack, we have been talking about petition, important work. I wouldn’t tive compensation, Jesse Fried—who’s executive compensation and long-term oppose such a rule; but since we’re at a here with us, by the way—wrote a incentives as a Nation for a very long law school, I want to push back a little. paper in the University of Pennsylva- time. And far from solving that problem, Suppose companies were required to nia Law Review about a decade ago we haven’t even come close. We have a lot make disclosures about different forms where he recommended ways to adjust of work to do on that issue. of human capital. Now, is your thinking compensation to encourage long-term that such disclosures would encourage performance. In particular, he said Should Companies Aim to Address corporate managers to do a better job of that companies should force CEOs to Social Problems? thinking through, say, their human capi- keep their stock. It’s a great paper with Coffee: The third and last of our three tal investments by being held accountable great suggestions for change. But we’re topics is whether corporate managers for such investments? not following them. Dodd-Frank, for should be considering environmental example, contains a number of provi- and other issues, or is that some kind Williams: Possibly, but not necessarily. sions that would help corporate boards of political determination that’s beyond and managers understand and disclose their competence and expertise? Jackson: That’s, I think, what Colin to investors whether or not they’re would say, too. While favoring such taking those steps. Of all the thousands Cynthia Williams: I’m wondering if it disclosures, he would probably also say of regulatory initiatives in Dodd-Frank, makes sense for us to finesse or side- that, in cases where shareholders and there are four rules that remain unfin- step the shareholder versus stakeholder managers agree that what might be best ished. And all of them have to do with debate just by emphasizing one of for long-run shareholder value ends executive compensation. Colin Mayer’s points: the importance up hurting employees—say, shutting of measuring corporate performance down an unprofitable plant—they will Coffee: And they never will be finished. in terms of increases in—or depletions continue to agree to pursue the value- of—not only physical or financial capi- maximizing course. All disclosure does Jackson: Right, and that’s not a coinci- tal, but also of human capital, social in such cases is provide transparency with dence. One of the most troubling things capital, and natural capital—which are respect to that agreement. I’ve seen as a Commissioner is that many all of course critical inputs into the firm. Now, I think Colin might push of the corporate behaviors that are most If companies were required to disclose for something more in such a case; he challenging, or most hard to understand, more information of this kind, we might want boards to intervene and are driven by short-term incentives. As might be able to avoid the shareholder maybe say no to such decisions. So, I said earlier, I try hard not to be mad versus stakeholder debate. By so doing, even when managers could agree with at people who do what they get paid to we would be asking corporate manag- their shareholders in perfectly transpar- do; I try instead to change the regulatory ers and boards to measure and disclose ent terms that it would make sense to framework that affects how they get paid. the effects on all important stakehold- shut down a plant and lay off workers, I’ll give you an example. I did ers of the actions that they are taking, managers would be prevented by their a speech about a year ago on stock regardless of whether they consider the boards from making such a decision as a

42 Journal of Applied Corporate Finance • Volume 31 Number 3 Summer 2019 ROUNDTABLE matter of fiduciary obligation to consider many breadsticks should go on a table, smart people in this room to help answer. all stakeholders. but which molecules a major pharma- But, as Jeff and Ron point out, the hedge ceutical company should be investing its funds, by virtue of the large positions Williams: We don’t even have to go R&D dollars in. they take in individual companies, may that far into the fiduciary duty argu- And what’s important here is that the well be the only outside investors with ment. Boards and managers are already institutions seem increasingly inclined the incentives and capabilities to ask making decisions that affect social capi- to support these people. Though Black- those questions. As Ron and Jeff show, tal; and by disclosing such effects, they Rock now votes only 20% of the time the large institutional investors, and would be forced to explain and perhaps with the activists, that number is going especially the indexers like Vanguard justify them to markets, and in the up. Vanguard votes with activists 30% and BlackRock, have very weak incen- court of public opinion. I also think of the time. And for T. Rowe Price the tives, and limited capabilities at best, to such accounting could help solve Jeff’s number is 50%. do the kind of fundamental analysis that political problem, which is to persuade The government obviously also gives them the confidence to take such Congress to agree to a new social insur- believes in their “superhumanness,” in large positions in individual companies. ance scheme. And, finally, we might be part by giving them lower tax rates than But all that said, Trevor, you’re not providing accounting firms with a new any other working Americans. And it wrong to point out that our securities business opportunity from providing allows them to circumvent rules like laws are set up in a way that these folks new or better measures of these kinds of 13D that were put in place to ensure can and do take advantage of. And as implications and more information. people know when they’re sneaking up a Nation, I think what we should be on companies. asking is, are those the folks who should Jackson: I think those disclosure propos- So, since everyone recognizes that be setting our corporate agendas? I think als are important steps forward. But what these people are really a master race of it’s a question to which the answer is not I want to avoid is holding up a potential people, should we really be worried that obviously yes. solution as complete when it’s not. My they are asserting so much power? We’re goal with this kind of disclosure is that basically giving it to them. Coffee: We’ve reached the end of our it be designed to encourage companies time. Now that we’ve heard Rob speak, to make the investments that we know Jackson: Trevor, I think the concerns how many of you agree with me that he they are making and should continue you’re raising are very real, and I want should go after the big prize? to make. The challenge would then be to be specific about the way in which coming up with measurement devices, they’re real. In my second year on this and that would be an interesting debate. faculty, Jeff Gordon and Ron Gilson And I’m sure the accountants would be wrote a paper about the degree to which happy to help us. hedge funds have increasingly been setting the agenda that gets in front of Curbing Shareholder Activists? investors. Though first published in the Trevor Norwitz: Rob, you’ve expressed Columbia Law Review about five years concern about the concentration of ago, it was just reissued as the lead article power in the hands of too few people. in the Spring 2019 issue of the Jour- But I think we need to remember that nal of Applied Corporate Finance—and I these are not just ordinary mortals. What strongly recommend it. we’re talking about here is a race of super- The question raised by this article— men. We have one person who at the and the one that we have to ask moment is trying to take over the board ourselves—is whether the hedge funds of directors at Magellan and Dollar Tree, are the folks who should be setting who did take over Papa John’s Pizza, and that agenda. Should they be the people tried to take over the board of Bristol- asking the question about breadsticks or Myers Squibb and stop a big transaction. molecules? I think that’s a really valid This is a person who knows not only how question to ask, and I’ll leave it to all the

Journal of Applied Corporate Finance • Volume 31 Number 3 Summer 2019 43 COLUMBIA LAW SCHOOL SYMPOSIUM Corporate Governance “Counter-Narratives”: On Corporate Purpose and Shareholder Value(s)

SESSION IV: THE LAW, CORPORATE GOVERNANCE, AND ECONOMIC JUSTICE

Columbia Law School | New York City | March 1, 2019

Leo Strine Jill Fisch Chief Justice, Saul A. Fox Distinguished Delaware Supreme Court Professor of Business Law, University of Pennsylvania

Eric Talley Bruce Kogut Professor of Law, Sanford C. Bernstein and Columbia Law School Company Professor of Leadership and Ethics at Columbia Business School

Mark Roe David Berg Professor of Law, Harvard Law School

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he three panels we heard this morning have discussed signif- T icant aspects of this emerging movement toward the idea of stakeholder- as opposed to shareholder-focused governance. But this is hardly a new debate. …You can easily trace today’s shareholder vs. stakeholder debate at least as far back as the 1930s. – Eric Talley

Eric Talley: Good afternoon, I’m It’s great to have you here. three panels we heard this morning Eric Talley, one of the co-directors of To Mark’s left is Jill Fisch, the Saul have discussed significant aspects of this the Millstein Center. I teach and do Fox Distinguished Professor of Business emerging movement toward the idea of research in corporate law, M&A, corpo- Law, and co-director of the Institute for stakeholder- as opposed to shareholder- rate finance, contracts, and business Law and Economics, at the University focused governance. But this is hardly stuff generally. And it’s a great pleasure of Pennsylvania. Jill does extensive work a new debate. Even the Milton Fried- to moderate this panel here this after- in corporate law and governance as well man contribution in 1970 was really noon. as securities regulation. Jill and I have just a weigh point along the road. You We’ve decided to do things a little known each other for over 25 years, can easily trace today’s shareholder vs. differently, and to ask each of our four having first met when we were green, stakeholder debate at least as far back panelists to make statements before we young professors. as the 1930s. start mixing things up. Before we get But for me personally, the debate started, let me run through a brief set Jill Fisch: You were green. goes back to an academic symposium of introductions. nearly two decades ago, where I was a In the power stool here is Chief Talley: Well, I guess so. But for the panelist alongside some dude named Justice Leo Strine from the Delaware record, we were both only 10 years old Vice Chancellor Leo Strine—and it was Supreme Court. As well as a good at the time. on exactly the same topic. And to prove friend, Leo is a leading light of corpo- And then to my left is Bruce Kogut, it, let me just quote from the article Leo rate law, well known to practitioners, the Sanford C. Bernstein and Company published from that symposium, in academics, other judges, and regulators Professor of Leadership and Ethics at 2002 I think it was: and legislators. And more important, Columbia Business School. Bruce is a The predominant academic approach by wearing jeans for this event, he’s leading national expert on corporate to the purpose of the corporation holds that effectively given us all the right, had we governance and ethics from the business it exists primarily to generate stockholder chosen to use it, to ditch business attire side. He teaches a course in governance wealth and that the interests of other for the panel. at the business school, as well as a new constituencies are incidental and subordi- After Leo will come Mark Roe, who class in business strategies for solving nate to that primary concern. The school is the David Berg Professor of Law at social problems. And having sat in on is dubious of allowing corporate boards of Harvard Law School. Mark’s teaching that class, I’m a big fan of his teaching directors to consider values other than the and research focus on corporate law, as well as his research. best interest of their current stockholders. governance, and bankruptcy. Many So, now that you’ve been intro- Another string of thought, however, has of you know Mark because he cut his duced to our cast of characters, we’re deep roots as well and sees the corporation teeth and his checks here in Morning- going to kick off the panel with Chief as a societal institution with responsibili- side Heights for many years as a member Justice Strine. And I want to be a little ties larger than the provision of returns to of the Columbia Law School faculty. So bit of a provocateur before I get you the current stockholder base, a base that notwithstanding that improvident move rolling, Leo, because I know I won’t often comprises largely transient equity north, welcome back to the fold, Mark. have much of an entrée afterwards. The holders with no long-term stake in the

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fate of any particular corporation. In this corporate law, but not nearly as far as my a professor at Columbia Law School, conception the corporate board of directors learned friend Colin Mayer does. But I’m Adolf Berle wrote an article saying owes duty to the corporation itself rather guessing that most people in this country basically the following: We have not yet than the shareholders, and in weighing any have forgotten what the word “general” had a New Deal. There’s now a group appropriate course of actions, the board is means in “Delaware general corpora- of people down in Delaware working entitled to think about the well-being of tions.” When corporations got their with New York lawyers on corporate other constituencies. start in this country—though don’t tell law. Our general corporation statutes are These competing arguments are the late Justice Scalia or Chief Justice getting more and more general and less appealing because they make us feel better Roberts this—there was no such thing as particular. And we’re concerned about about whichever of the two models we tend general corporation statutes. The govern- this phenomenon because corporations to favor. Best of all, they provide courts and ment chartered all corporations for a are less closely held and the people who other decision makers with a way out of a specific purpose that a very long charter own the equity have less of a stake in a basic conflict. If a board of directors can spelled out. And the ultra vires doctrine particular corporation, corporate manag- plausibly claim that the decision to reward had teeth, which meant that companies ers may feel more free to act in ways that employees with a pay raise now will pay off could only take actions that were related hurt their investors, and other people too. in the long term, and provide a return for to their state-sanctioned purpose. So, Berle’s article basically concludes by shareholders, the need to side with one of But then, between 1880 and the saying, “We better keep corporate law the two approaches magically disappears. 1920s, general corporation statutes and require that companies stick to their To me, Leo, that passage can emerged that, though using a basic knitting by putting their shareholders be read to make a sly type of defense template, had lots of provisions allow- first; because if we allow managers and of old-school shareholder primacy ing specific acts. One common one boards to do anything other than that, doctrine. And so, my question to you said that, if you wanted to do a merger, they will then justify their actions by is, what if anything has changed during you had to get the unanimous vote of claiming the greater social good, and they the last 15 to 20 years since you wrote your shareholders. And the ultra vires will end up being accountable to no one.” that? Why is this debate coming up doctrine stayed in effect, ensuring that So into this debate comes Merrick again and again? And is it now different companies were prohibited from taking Dodd, a Harvard Law prof who looks from the way it’s come up during all the actions not explicitly allowed by their like a lib when he points with approval years you’ve served on the bench and in charter or by law. to the head of General Electric’s state- practice? When the general corporation law ment: “We’re not simply about our statutes emerged and corporations were stockholders. We’re about society and Leo Strine: I think the debate’s never allowed more flexibility, one of the first everybody else, and why shouldn’t we gone away, and I’m not sure it’s differ- reactions was to regulate the corpora- be able to balance all these interests?” ent today than in the past. But the scope tion’s ability to act on behalf of society. Well, that sounds kind of “woke,” to use of the issue, and the consequences of Really anti-business people, like the New today’s word. But what was Dodd really getting it right, have both gotten bigger. York business people who supported arguing for? But let’s start with three words we Teddy Roosevelt, were among the first Again, it’s important to remember haven’t heard yet today: “The New to support regulations banning political that this is the early ’30s. Dodd was Deal.” I’m not talking about the Green contributions by corporations. arguing that we, the business elites, have New Deal, although I support aspects of But that brings us to the great debate learned our lessons. And we know how that. I mean the New Deal. And I want between Adolph Berle and Merrick to fix the things that brought you this to mention two other words: Citizens Dodd, which has often been misun- Depression, and the height of inequal- United. It’s surprising to me that here derstood. It was a “gotcha game”—one ity—and I’ll come back to this, because we are at 2:00, well past the midpoint of familiar to academics—where you take we’re now seeing levels of inequality we a full-day meeting, and we haven’t heard a part of your opponent’s thinking and have not seen since that era. either of those mentioned. try to score a point by taking it out of So, here’s Adolf Berle, the brain I also want to go back a little bit in context and distorting it. truster who wrote the key campaign the history of the corporations, and of In the early 1930s, when he was still speech about the economy for

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n terms of the ESG movement and everything we have to do, I I think we ought to be very careful not to forget, or confuse, what the Securities Acts were about. It’s important that everyone understand what corporations do—both what they are supposed to do for society, and what they are not supposed to do. That’s something everyone should know, whether they own publicly listed securities or not. – Leo Strine

Roosevelt—and I’m not going to since I was nine years old. came with that kind of economy. The pretend that the framers of the New But when mentioning Bernie the New Deal provided that scope. And as Deal knew exactly what they were doing other day, I had to point out that, things turned out, Franklin Roosevelt at every moment because Roosevelt was although Bernie will embrace the and others—including Adolf Berle, who an experimenter. But in his debate with term “socialist,” he has never called for was involved in the State Department by Dodd, Berle was basically saying, “BS state control of the means of produc- then—had the vision that allowed the on you. I’m a supporter of the idea that tion. What he has said is that there are New Deal to go worldwide. the corporation should operate within a places in the world like Scandinavia What happened was a period of structure—and we’re now in the process and Germany where market econo- American and European, or OECD, of creating that structure. And the reason mies have succeeded while taking hegemony where people thought that we need that structure is that we can’t into account the needs of the many. you didn’t actually need binding protec- just trust economically powerful people European social democracy is the tions. So we had this period of economic to do what’s best for everyone else; descendant of the New Deal. There’s security in Europe. Because of Adolph people with economic power should act a great biography of Clement Attlee Berle and his Delaware colleagues, with economic accountability—with showing that he was a huge admirer businesses have continued to operate power comes responsibility.” of the New Deal and that his Labour within a structure. And Berle himself Another clear lesson from the government—and by the way, no actually said something like this in the 30s—something I also like to focus government was more anti-Communist 1960s: With my arguments in corpo- on—is that power drives purpose. and more anti-fascist than Attlee’s— rate law so focused on stockholders, So, what happened in the U.S. when put in place many of the elements I think we can now actually relax some we adopted the New Deal? For all its of the economic security program of the legal protections for shareholders a imperfections, it got us through a time adopted by the New Deal. And much little bit because I feel more comfortable of rising authoritarianism, a time when of this was later adopted by the EU. now that businesses are operating within Communism had an appeal—even There’s also a period of French constraints. within our borders. We had people like history called the Trente Glorieuses—the When Marty Lipton wrote his Father Coughlin and Huey Long. People 30 glorious years—that I think is worth article in the Chicago Law Review in forget this. I got quoted using the “C” talking about. What was that about? 1978, he said that it’s got to be passé word the other day. I can’t be political, Well, think about what the New Deal to think that businesses will focus of course, because I’m a judge. But it’s accomplished. The scope of the Ameri- only on profit, because they can’t any pretty obvious who I’m going to support can economy had become nationwide, longer; they have to focus on the safety in the next presidential election, and it’s but the regulatory framework had to be of consumers. They have to focus on not Bernie. It’s the person I’ve supported extended to address the new realities that the environment. As I was saying to

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Colin, we no longer have foggy London world’s most famous Dutch rock band? enough. Well, sure, I’d like a bigger pie, because of government regulation; foggy It’s U2. U2 is Bono, and Bono suggests too. But if the people with the capital London was pollution. stuff for everyone to do. And you know shared the same frickin’ amount of the But I also want to give some credit what he did? To avoid paying his taxes, pie that used to go to the people who to Milton Friedman, even though I don’t he’s become a Stichting, a Dutch limited sweat, there’d be a lot less inequality. The really agree with anything the man said. liability corporation that ensures he pays fat cats at the top grab a bigger share But in the context in which he wrote as little income tax as he can. of the pie, and the representatives of his famous article, his ideas are not And that brings me back to the ordinary people—the money managers nearly as extreme as they’re now viewed question of economic inequality. who hold our equity capital for us—have by students. And here’s the reason. He What’s happening now is what I call the been in some ways part of the problem. wrote that in 1970, when there were “re-aggregation of capital.” I’ve written Take corporate California. I love very strong regulatory protections and talked about the “separation of California, but California started to for workers—not just in the EU, but ownership from ownership” for a long have a problem with social underin- even in the United States. If a union time. What is the most federally subsi- vestment during the years when they got elected and you didn’t recognize dized industry in the United States? It’s had to have referenda to pass anything. them, the NRLB would actually do money managers. Why do I say that? Institutional investors have made public its job, kick your butt, and make you Because for everyone of us who works corporations into the same kind of refer- bargain with them. So when Friedman and pays taxes, some of our money is endum-driven institutions. When you wrote that business should stick to its going to money managers every week. subject the boards of directors to the knitting, while staying within the rules And they hold it till we’re 60. If we save immediate whims of the marketplace, of the game, that may not have been so for retirement, or to send our kids to increase proxy votes on all kinds of bad—because the rules of the game were schools like Columbia, then part of your proposals, and the market puts pressure actually quite vibrant then. paycheck is going to a money manager on them, boards are going to respond But what’s happened since then? who gets fees for managing it. to that pressure. And one of the biggest Well, in international trade we have Now, when your money goes to a effects of that market pressure is, again, worked to open borders. That was part money manager to buy shares, you don’t this shift in gain-sharing from the of the vision, right? But what did we have any control over how your shares people employed by, and who sweat for, globalize? We globalized the power of get voted. The intermediaries do. And corporations to the people who supply mobilized capital. We made countries over time, regulation—the rules of the the capital. open up their markets. But did we game—have gotten weaker. The things So with that said, I think we have to provide global protections for working that protect workers have gotten weaker. talk about Colin’s question of power and people? No, we did not. Did we there- Particularly in the United States, the purpose. My only disagreement with fore expose workers in our communities bargaining power of workers has gone Colin is this: Do I think there’s an insight to competition from other places that down. Where we’ve seen moderately to be had in the design of corporate law treated workers less fairly? Yes, we did. less inequality in some OECD nations, about the purpose of the corporation? Did we shift jobs to places where people that’s because even at companies that Sure I do. But when corporations were could externalize their environmental don’t have unions, they have mandatory founded, most of them weren’t all over costs in a way that you couldn’t in the work councils that give labor power in the globe. When corporations did well USA? Sure we did. those societies that we don’t. and expanded, they tended to create We also allowed countries, states, So, with the increase in the power jobs in the communities in which they and municipalities to get played off of capital over corporations, the gain- operated. And the people who worked against each other and shift the tax sharing between workers and the for the corporation, managers as well as revenue burden away from business equity holders has shifted profoundly employees, often lived in the community and toward ordinary people. Look toward capital. I recently heard some where it operated. So there was more of at the share of school taxes and other billionaire hedge fund guy say the real a connection to a particular community things paid in the United States. We problem since the financial crisis is that and social setting, more gain-sharing as a also allowed hypocrisy. What’s the the “economic pie” hasn’t grown fast matter of course. But with the globaliza-

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tion of the economy, and all the overseas prevents the board of directors of a tion that actually provided four types investment, a lot of those connections prospering corporation from allocat- of contraceptives for its workers as have eroded—and that’s created a ing a larger share of that prosperity to part of its healthcare plan. But when problem for the corporation. the workers—that is, the same share as our Congress passes a bill providing The answer of the institutional would have been allocated in 1975 or for these contraceptives, suddenly it investor community to this problem 1965. These decisions that favor capital becomes a religious issue and women has been to rely on what I call “the have all been done by these boards of are prevented from having a healthcare thermometer.” And the thermom- directors and their managements. Do plan where an employee wants to use a eter is the “independent director.” I think that’s because they’re evil? form of contraception that the control- The independent director acts as a No, it’s because they operate within ling stockholders consider against their thermometer of the market. Indepen- a power accountability structure and religious beliefs. Well, whose pay was dent directors are defined as people they’re answerable to one constituency. it that went towards those contracep- who have absolutely no connection to Milton Friedman’s argument tives? Can controlling stockholders the company that would give them any that corporate law should stick to its keep employees from receiving key, reason to favor one corporate constitu- knitting—focusing on the relations legally required healthcare benefits just ency over another; they’re supposed to between managers and stockholders— because the controllers object? But the be resolutely impartial in that sense. But and leave the rules of the game that Hobby Lobby ruling shows that we have they are supposed to represent the long- protect other constituencies to be set a court system that puts the rights of the run interests of the shareholders; they by the political process—is no longer as few above the many. do this by acting as an instrument that credible as it once was. And this is where Now, I’ve had a little argument with recognizes what’s going on in the market Citizens United comes in. And here, Jeff, some of my friends who cited that case to and making sure that the market’s view I want to take issue with your use of the say, “See, corporations can be about more is understood by management and the term “asset owners.” These people are than stockholders.” And my response is, rest of the board. mostly not the asset owners; they are “That’s a weird case to cite for anything But if that’s the corporate purpose, direct fiduciaries, intermediaries, of good, because it’s a bad case.” And here’s what about corporate power? Eddie American investors. Most Americans why it’s bad. Why could the owners of a Cochran wrote a great song called don’t own Google and Apple directly. company prevent their employees from “Summertime Blues” in which a Their shares are held—or controlled and having access to contraceptives through teenager, after complaining he can’t get voted—by Vanguard and Fidelity. Fidel- their company health plan? Because they the car to go out with his girlfriend, says, ity, which has a lot of my money, is now are the stockholders. This decision wasn’t “Well, I called my Congressman and he the third-biggest indexer. And indexers about a larger purpose. It happened said, quote: ‘I’d like to help you, son, are not asset owners; they’re just as much because some particular people control but you’re too young to vote.’” In the an intermediary as anyone else. The asset that corporation. American polity, corporate law says that owners are the actual working people But, now let’s talk about Citizens the only constituency with the right to whose money goes into the system. United. Jeff, the third thing you didn’t vote or do things is the stockholders. Now, in terms of rules of the game, mention about the asset owners is that At the governmental level, our polity we have Citizens United v. Federal no one invests in index funds so that doesn’t stop society from deciding to Election Commission, which expanded the ultimate companies can spend your make contributions to the environ- political spending by corporations, and money for political purposes. Whether ment, social responsibility, the arts and an interesting case called Burwell v. you’re a conservative who doesn’t want cultural activities and from prioritizing Hobby Lobby Stores, where the Supreme those Silicon Valley folks talking their these things. But within the corporate Court ruled that owners of the stock good game about whatever they think polity, the people who are the citizens, of a family-owned corporation can’t be is the cool social issue of the day, or the people who really matter and have a required to pay for insurance coverage whether you’re somebody who doesn’t vote, are the stockholders. for contraception under the Afford- want the people who brought us carbon But all that said, there’s been no able Care Act when it violates their and who suppressed the research about Delaware case in the last 20 years that religious beliefs. We had a corpora- it controlling our environmental policy,

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there’s pretty much a consensus that we shortcuts get cut out over time. Exter- What we actually need to do then is to give the money over because we have to nality costs are borne by all universal come up with better rules of the game, save for retirement, and we don’t want owners, as Colin says. I agree with him with policies that make sense across corporations using our money to take fully on that. If you can operate in a borders—and not allow the kind of political stands we might not agree with. sustainable way, you can actually treat arbitrage that we have, not compete But what have we done? We’ve freed your workforce better. But things are with our basic values, and not pretend our creation to actually act on the rules going to be a lot harder if you’ve still got that any of the prosperity we have was of the game. And the people in the to compete with the WorldComs that solely the result of functioning markets. middle who are talking a good game— engage in fraud, or with energy compa- That experiment’s been done. That’s they abstain. They won’t even vote: nies like Massey that operate with too when we had child labor, and no limits BlackRock, Fidelity, and Vanguard will few people—all because the punk-ass on pollution. That’s what caused the rise give them a pass. Now they will vote on analysts are calling you up and asking of fascism and communism—the failure issues like disclosure. But they all know why you can’t replicate the performance to address the problems of a system that’s that no one authorized their vote. They of scum, and you don’t have a credible solely focused on lucre. We would not also know the better CEOs don’t want answer—or you get beat up for giving have the Internet if it were not for Al the ability to give because a legal prohi- your workers a 4% raise, which we’ve Gore. The government invented the bition on giving allows them to stay out seen these analysts do. Internet—and Al Gore passed a bill that of that business. But when you can give, But there are also things that we gave it to the private sector. The indus- you can get steamrolled into doing it. need to do on the government side. And try in California could not make chips We now can’t even trust the rules of the organizations like Aspen are working if they couldn’t wash them in water, and game to be set because if the Leviathan on it, asking questions like: Can we they wouldn’t have had water if it weren’t that we’ve created can actually take our tax in a smart way? Should we reduce for government. money without accountability and use speculation? Can we actually give more In the case of many of the drugs that it, then guess what they use it on: to breathing room to the asset managers to save people, much of the research in basic influence the very rules of the game that think long term? How about a gradu- science has been funded by government. the other constituencies are supposed to ated capital gains tax? Or a fractional Our most effective form of philanthropy rely upon. trading tax to stop fund hopping? How is when we pay our taxes. A billionaire And let me finish by giving a shout about investments in infrastructure? who pays an effective tax rate of less out to my friend Judy Samuelson at We will not solve this problem just than 10%, but then gives 1% to charity The Aspen Institute. A lot of us have by looking within the domestic U.S., or and gets feted, is socially irresponsible been working on things that are not within the EU alone. We cannot shut compared to a working person who pays one-dimensional. I do not disagree at our eyes and our hearts and souls to the an effective tax rate of 20%. So I think we all with the idea that corporate gover- need for the developing world to move need to talk about all these dimensions, nance alone is not a solution. But is it forward. But we don’t have the time to but we cannot talk about the purpose important? Is the way in which people learn the history lessons as slowly as we of corporations without considering vote, and the space that the investors learned them before. If we allow the the power structures within which they give to the people running corporations kind of environmental destruction that operate. to operate in a sustainable, responsible we had in the 19th century, if we allow So, Adolf Berle was a realist. He’s way important? Sure it is. And is there ten more years of that to go on, we won’t one of my heroes, and so is George something to the idea that the longer- have a planet. Orwell. If we want to do good things, we term interests of workers are actually We shouldn’t have to be debat- have to be clear-eyed about what we’re consistent with those of most human ing minimum wages any longer. We doing and how we’re doing it. That’s a investors, and that higher long-run know they make sense. We should tradition at Columbia Law School, and returns to stockholders depend on our not be debating child labor laws. We I’m proud to be here—and I probably doing a better job of protecting the know they make sense. We know took too much time. But that’s my interests of workers in society? that working people need economic counter-narrative. And I’m wearing Levi I think there actually is. Because security. All the OECD nations agree. jeans, which, last time I checked, were

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he economy-wide evidence does not point to stock-market- T driven being a big problem... There’s something else going on. – Mark Roe

still being made in the United States of we could talk about for my 10 minutes. facing the U.S. economy today. For America. I’m not going to talk about the first example, Marty Lipton, in his 1979 issue because I agree on the essentials Business Lawyer article on takeover bids, Eric: Now, we will hear from Mark Roe, with Leo. If Leo were campaigning for said that “It would not be unfair to pose who, as I told you earlier, is the David office, he would get my vote on these the policy question whether the long- Berg Professor of Law at Harvard Law issues—because I share most of Leo’s term interests of the nation’s economy School. Mark, take it away. vision of what’s wrong and what needs should be jeopardized to benefit specu- to be fixed. I’d just add that in looking lators.” And Joe Biden recently wrote A Closer Look at Stock-Market- for solutions, we should be guided by the a Wall Street Journal op-ed stating that Driven Short-Termism utilitarian principle of seeking the great- “Short-termism is a problem. It’s a Mark Roe: Thanks, Eric. When Jeff est good for the greatest number. Most problem in the way it hurts employees asked me to be on this panel, he suggested of us are, I think, but we can disagree and workers.” And from the business that I look through Leo Strine’s published on how to get there. Even Milton Fried- community we’ve heard similar state- work in the law reviews to identify the man’s shareholder primacy view, which ments from Warren Buffett and Jamie big themes. I teach one of Leo’s articles Leo criticized, was justified by the expec- Dimon in the Wall Street Journal. every semester in a corporate law semi- tation that it produces the greatest good Justice Strine is in this consensus nar. And so I’ve got good familiarity with for the greatest number. camp. One of his articles has the title, them and know their big-picture themes. The second big theme in Leo’s “Can Corporations Be Managed for Two major issues keep coming up in writing is corrosive corporate short- the Long Term Unless Their Powerful Leo’s work, one of which we heard a lot termism. The theme of this conference Electorates Think in the Long Term?” In about in his presentation just now. The is “narratives and counter-narratives.” But another article, Leo states that “directors second one Leo mentioned only briefly here the question of what is the narrative are increasingly vulnerable to short- in his talk, but it plays a big role in his and what is the counter-narrative lacks a term objectives, sacrificing long-term writing. clear answer. The most common narra- performance for short-term shareholder The first of the two big themes is that tive is that short-termism is rampant and wealth.” to be a successful institution, the public a deep problem, and Leo strongly believes corporation has to work for the average that. So what I’m now going to provide Four Strands of the person, and it has to be seen as working is thus a counter-narrative: namely, that Short-Termism Argument for the average person. The second theme the economy-wide data does not point When I took a comprehensive look at is that stock-market-driven corporate to stock market short-termism being a the literature on the subject, includ- short-termism, with all the relentless deep problem. ing Leo’s, I found that there are four trading and hedge fund interventions, Short-termism has been seen as a main, interrelated consequences asso- deeply damages the American corpora- deep problem for a long time, with there ciated with stock-market-driven tion and economy, and we’ve got to do being something close to a consensus short-termism. One focuses on cutbacks something about it. now that market-driven short-termism in corporate capital expenditures. A Those are two big-picture topics that is one of the major economic problems second is that pressure on companies

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Slide 1 than it is in the United States. Capital Economic Change: Capex Is Down throughout the OECD expenditures to GDP in Germany and The Similar Capital Expenditure Trendsthroughout the OECD Japan, where the stock market plays a much less important role in corporate OECD Germany finance than in the U.S., have declined 30 30 more sharply than in the U.S.—the

2 2 country where, with the possible excep- tion of England, companies rely most 20 20 heavily on the stock market.1 1 1 190 19 192 19 199 2000 200 2012 190 19 192 19 199 2000 200 2012 So, is the stock market the likely culprit? Maybe. But I’d suggest Japan U.S.A. instead that companies now operate 3 30 in a post-industrial economy that is 30 2 fundamentally different from the prior, 2 hard-asset-intensive economy. Today’s 20 20 companies are also making more 1 1 efficient use of capital equipment than 190 19 192 19 199 2000 200 2012 190 19 192 19 199 2000 200 2012 in the past. The comparative data should

Source: The World Bank National Accounts, gross fixed capital formation (% of GDP), https://data.worldbank.org/ at least give us pause before jumping to indicator/NE.GDI.FTOT.ZS?end=2016&start=1960&view=char (accessed Jan. 2, 2018). the conclusion that the American stock market is causing capital expenditures to decline. for distributions—that is, dividends to cut back on productive investment Buybacks as draining cash? But what and stock buybacks—is starving compa- to generate higher near-term earnings about the second charge? Are corporate nies of cash. The third is that these cash and returns on capital. But there distributions via stock buybacks leading shortages are leading to cutbacks in are simpler, and more plausible, to a cash shortage? Stock buybacks are, research and development. And fourth, alternatives. One, we’ve just come of course, one of the castigated conse- and perhaps most troubling, is the through a weak recovery from the quences in the current debate. And claim that stock markets in their obses- financial crisis, and the recent big drop there’s no doubt that there’s been a sion with near-term profit don’t support in corporate capex is likely a lingering significant increase in buybacks by longer-term innovation by giving inno- effect of the crisis. But there’s another the largest U.S. companies—say, the vative companies full or fair valuations. possibility we’ve got to look at— S&P 500. But what many of us fail The overall consequence of these that there’s something much more to recognize is that there’s also been a four elements is that we suffer from a fundamental that is happening in the comparable increase in net borrow- much weaker economy than we would economy that’s causing companies to ings by the S&P 500 companies over have otherwise. And let’s just look at use hard assets less and soft assets more the same period. In fact, it looks as if each of these four complaints—the than ever before. And these soft assets since the financial crisis, the entire large four big themes of the short-termism don’t get recorded on the balance sheet. corporate sector has maintained roughly literature. Here’s a slide that I think is worth the same level of total capital while Capex. Start with the decline of looking at again and again (Slide 1). As recapitalizing itself, replacing equity corporate capital spending. And it you can see in the bottom right, capital with increasing debt. And with interest is declining as a percentage of GDP, expenditures as a percentage of GDP in rates at near zero from 2009 until now, there’s no doubt about it. But why is it the United States have been falling for this would appear to be a sensible thing declining? the past several decades. But when you The dominant hypothesis has been look at the rest of the OECD over the 1 The underlying sources for the graphics and data in this talk can be found in Mark J. Roe, “Stock Market that stock market trading and activist same period, the slope of their decline Short-Termism’s Impact,” University of Pennsylvania Law interventions have forced companies in capital expenditure is actually sharper Review 167:71–121 (2018).

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Slide 2 Slide 3 Rise in Both Net Stock Buybacks and in S&P 500 Cash-on-Hand as a Portion of GDP, Net Borrowing in the S&P 500, 1985-2015 1971-2015

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00 300 00

200 00

00 100 003

002 0 19 19 199 1991 1993 199 199 1999 2001 2003 200 200 2009 2011 2013 201 001

Net Buybacks & Long-Term Borrowing, in Billions 100 0 Net LonTerm Borroin Net Bubac 191 193 19 19 199 191 193 19 19 199 1991 1993 199 199 1999 2001 2003 200 200 2009 2011 2013 201

Source: The Compustat database was the source for the buyback and cash-on-hand Source: The Compustat database was the source for the buyback and cash-on-hand data. Compustat Industrial [Annual Data], Standard & Poor’s [accessed various dates in data. Compustat Industrial [Annual Data], Standard & Poor’s [accessed various dates in Jan. 2018]. Retrieved from Wharton Research Data Service. Jan. 2018]. Retrieved from Wharton Research Data Service. to do, firm by firm. Debt has become development expenditures have been the largest companies be future-oriented cheap, and companies have been issuing going up in the American economy companies. But this doesn’t look like a debt to buy back equity. noticeably more sharply than the GDP shortsighted stock market to me. This recapitalization may not end is growing. True, this kind of economy- So, to summarize what I’ve just up being good news for shareholders wide increase does not amount to an said, there is little evidence to support and the economy. It could be bad news irrefutable rebuttal to the short-termism the widespread consensus that we have if we have a recession in 2021 in which argument. We don’t know whether we a serious stock market short-termism thinly capitalized companies are forced might have had even more R&D in the problem that is destroying critical to struggle with heavy debt loads. But, absence of such stock market pressures. aspects of the economy. And there is again, this is not a buyback issue in the But we know that hedge fund activism no evidence that it’s killing research and sense that buybacks are starving the has gone up dramatically during this development or starving firms of cash. firms of cash; the companies are chang- period, yet we see no sign that such Why, then, is short-termism such a ing their capital structures, not getting activism and increased market trading prominent issue? I suspect it ties into the rid of capital. have been reducing R&D from what it first aspect I mentioned as one of Leo’s What’s more, any shortage of cash was. two big themes. There’s a widespread from buybacks or other payouts are The stock market fails to support sense that the large corporation is not unlikely to be causing cutbacks in capital innovation and the future. And this brings delivering the goods for the average expenditures for the simple reason me to the fourth and final claim about person, and that something’s gone that the cash balances of the S&P 500 short-termism—the stock market’s wrong with capitalism. companies have been rising steadily. failure to recognize and properly value My worry here is about the conse- The cash balances might be even higher corporate innovation and innovative quences of continuing to believe that without the buybacks, but U.S. compa- companies. If the stock market were stock market short-termism is the nies are not starved for cash. failing to value future-oriented compa- cause of big problems in the economy, R&D. The third prominent nies, we wouldn’t see that in 2018 the when there’s little or no economy-wide complaint about the short-termism five largest stock market caps in the evidence to support the proposition. of the stock market is that it’s killing United States are Apple, Amazon, If we persist in believing that short- corporate R&D. The reality, however, Microsoft, Google, and Facebook. Now, termism is the problem, we’re going as shown in Slide 4, is that research and maybe we should expect to see all ten of to have some seriously misdirected

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Slide 4 0011 Proportion of GDP Spent on R&D R&D Spending in U.S. as a Proportion of GDP, 1977-2015 001 001 19 199 191 193 19 19 199 1991 199 3 199 199 1999 2001 2003 200 200 2009 2011 2013 201 001 R&D Expenditures in the Non-Financial S&P 500, R&D in the- Non-Financial S&P 500, 001 001 1975-2011 Scaled by GDP, 1975-2011

001 001 30 1 1 300 001 001 1 20 12 001 0013 200 1

001 0012 10 GDP 0 of dollars) 0 0013 0011 100 Proportion of GDP Spent on R&D 0 R&D Expense (in billions 0 0012 001 R&D, as a Percentage of 02 19 199 191 193 19 19 199 1991 1993 199 199 19099 2001 2003 200 200 2009 2011 2013 201 0 0011 19 191 19 1993 1999 200 2011 19 191 19 1993 1999 200 2011 Proportion of GDP Spent on R&D R&D Expenditures in the Non-Financial S&P 500, R&D in the- Non-Financial S&P 500, 001 1975-2011 Scaled by GDP, 1975-2011 19 199 191 193 19 19 199 1991 1993 199 199 1999 2001 2003 200 200 2009 2011 2013 201 30 1 The R&D data is from the Department of Commerce’s Bureau of Economic Analysis, a standard government source R&D Expenditures in the Non-Financial S&P 500, R&D in the- Non-Financial S&P 500, 1 of economy-wide data. Bureau of Econ. Analysis, U.S. Dep’t of Commerce,300 National Income and Product Accounts, 1975-2011 Scaled by GDP, 1975-2011 1 Table 5.6.5, lines 2 & 6 (2017), http://www.bea.gov/itable/ [https://perma.cc/HM9A-7XM3].20 30 1 12 200 1 1 300 1 10 GDP 0 20 of dollars) 0 12 100 200 0 R&D Expense (in billions 1 0 remedies. For example, if we take a tremendous buildup in debt that will R&D, as a Percentage of 02 10 GDP 0

of dollars) 0 0 0 managerial100 perspective that Marty be destabilizing19 191 in19 the1993 next1999 200recession,2011 19 191 19 1993 1999 200 2011 0 Lipton’sR&D Expense (in billions 0 talk provided us earlier today, then we should be focused on reducing R&D, as a Percentage of 02 and if we0 identify stock market short- the debt,0 and probably on eliminating to figure out what it is and how to fix 19 191 19 1993 1999 200 2011 19 191 19 1993 1999 200 2011 termism as a deep problem, one of the or reducing the deductibility of inter- it. Thank you. remedies might be to give managers and est instead, of criticizing buybacks or boards even more discretion than they holding up some other corporate gover- Talley: Thanks, Mark. Before we ask Leo have now. And I think that would be the nance solution as the cure. to comment, I think it probably makes wrong way to go. So, maybe this is a good news as well sense to go through all of the presenta- Or, what if basic problems in the as a bad news story. The cardiologists of tions. So I want to move straight to Jill economy attributed to stock-market the world have come in and looked at Fisch. Jill, as I told you earlier, is the Saul short-termism result from other difficul- the patient and said, “You’re really sick. A. Fox Distinguished Professor of Busi- ties; for example, what if there’s too little We’ve diagnosed you as having a signifi- ness Law, and co-director of the Institute competition in the economy right now? cant short-term cardiac problem and for Law and Economics, at the Univer- Too little competition will frequently we’re going to need to operate.” But then sity of Pennsylvania. show up in declining investment in another doctor comes in and says, “You assets. An oligopoly tends to invest less actually don’t have much of a cardiology Is There in Fact a Corporate than a more competitive industry. If that problem. You’ve got a problem, but it’s Governance Problem? turns out to be true—I’m not saying it not a cardiology problem. It might be a Jill Fisch: Thanks, Eric. It’s a great plea- is, even though there’s more evidence of cancer problem, it might be Alzheimer’s, sure to be here. And Mark’s lead-in is significantly increased concentration in it might be Parkinson’s; but we’ve got to perfect because I’m not sure whether I the United States in the last 25 years than look more carefully, and the solutions see the glass as half full or half empty. of stock-market-driven short-termism— don’t seem to be easy ones.” There’s certainly something in the glass. then the corporate governance remedies What I think we can say is that, But in terms of the theme of that we would think about aren’t going based on the economy-wide evidence, counter-narratives, I guess I want to to help with the problem. If the funda- we don’t have much of a stock-market- question how much of a problem we mental problem with buybacks is not so driven short-termism problem. There’s have at all. The title of our panel directs much the buybacks themselves, but the something else going on, and we need us to think about the role of those who

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have power in the corporation and their for example, in the shareholder votes at results of that election have not led to an capacity to affect corporate purpose. But Exxon, Occidental Petroleum, and other increase in the federal minimum wage. let me start by asking the question that companies asking for greater disclosure But what have we seen since the Colin teed up this morning: Is there and board oversight about sustainability, election? We’ve seen a substantial some urgent need to rethink corporate climate change, and environmental risk. number of corporations privately purpose? We have heard a lot of really The greater focus of shareholders, raising the minimum wage that they smart people this morning who have in particular, on these questions is part pay their workers. Notably, they are had a lot of different things to say. I of the rationale behind the petition that taking this initiative without a national think rethinking is generally a good Cindy Williams and I submitted to the minimum wage requirement; they’re thing, but in terms of an urgent need SEC to require issuers to make sustain- doing it voluntarily. And despite the to change, I guess I’m not sure that I see ability disclosure. I see that petition as rhetoric we hear about the shareholder the emergency. an effort to force corporations to become primacy norm, the shareholders of these So why don’t I see a need for not only more sustainable, but more corporations are not hauling them into change? Let me start by asking the transparent about what they’re doing— court in Delaware and claiming this is question: how do we know when we and for corporate boards to engage in a breach of their fiduciary duty. In fact, need a change? Presumably the first greater oversight of ESG efforts and to in many cases, the shareholders seem to step is to identify a problem in the way provide shareholders with more infor- be applauding. So again, while I agree corporations are currently behaving. So mation in order to evaluate corporate that inequality is an issue that requires what is our data set? behavior. I think the most effective attention, what’s important is the fact Josephine Nelson talked earlier way to accomplish this is for the SEC that, without a “new paradigm” or a about the Volkswagen emissions scandal to set norms and expectations with “counter-narrative,” corporations are as an example of the problem we have respect to sustainability disclosure in paying attention to these issues and with respect to ESG. Volkswagen the same way that it has done for many engaging in an ongoing dialogue about concededly was a tremendous environ- other disclosure issues. The advantages the responsibilities they have to their mental problem—one that was made of SEC rulemaking are standardization employees and their customers. Today’s worse by the greenwashing that went on. and accountability, but federal disclo- debate about inequality is thus another But it was also an outright fraud. My sure guidelines also reduce the potential example of a compelling social problem, point is that we tend to hear about “the burden associated with having to comply but not, I think, of a crisis in corporate outliers”—the cases of egregious corpo- with the claims not just of shareholders culture. rate misconduct—and to extrapolate but also non-shareholder stakeholders. from those cases to believing that they So I see limited SEC rulemaking in Rising Expectations are representative of corporate behavior this area not as an attempt to mandate Why, then, all the hype over the need generally. I think that is a mistake. greater social responsibility by corpora- to rethink corporate purpose? I think My own experience suggests that tions or greater stewardship by investors, our expectations for what business is we’ve seen tremendous progress in but as a tool for generating data that supposed to do and what business can corporate efforts to identify and deal enables a range of decision-makers to do are changing. And there are a number with environmental risk. Corporations evaluate accurately what corporations of factors that have led to heightened are paying serious attention to these are actually doing. expectations. Businesses today are bigger issues and changing or modifying the Another social issue that has received than in the past. Bigger corporations ways in which they operate. Could they extensive attention in today’s discussion have greater potential impact—they do more? Maybe—and there’s obviously is the problem of wealth and income affect more people, they provide more a question with respect to identifying the inequality. Leo Strine’s comments jobs, they create bigger risks to the envi- appropriate benchmarks by which to mentioned an increase in the minimum ronment, use more natural resources, evaluate their performance. But corpo- wage as a possible response to this etc. Bigger corporations also have greater rate officers and directors are paying problem, and a higher minimum wage resources, which leads us to expect them attention to environmental issues, and was a high-profile topic of debate in the to do more. Shareholders, customers, so are shareholders. We see this reflected, last presidential election. Of course the and the public at large may be unwilling

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to hold the family-owned grocery store obligations to shareholders and the closely aligned with societal welfare. on the corner accountable for evaluat- broader group of stakeholders. I’ve had I guess I would urge restraint in ing and addressing issues in its supply any number of corporate executives accepting this premise, in large part chain. But when it’s Amazon that’s approach me and ask the question: because I am not sure that the idea running the grocery store, it’s a differ- “We face pressure to consider this of defining a single social purpose for ent story. We reason that if a company societal objective or interest, and we today’s large corporations makes sense. earns $11 billion in profits, it can have take it very seriously. But we also have First of all, who is going to a meaningful role in addressing broad the obligation to protect the interests choose the corporation’s purpose? social concerns. of our shareholders. How do we strike Will it be the board of directors? The At the same time, the fact that a reasonable balance, and where do we executives? Representatives of the largest businesses are global makes it more look for guidance on those points?” shareholders? Representatives of labor? difficult for them to sort through and The corporation’s obligation to These are all people who have some respond to these increasing expectations. consider broader societal interests is degree of decision-making power, but They need to make choices about how to further complicated by the fact that that power extends to different issues balance the different cultures, the differ- corporations are interconnected. What and they exercise that power in different ent norms, and the compelling needs in one corporation does affects what other ways. One clear trend over time has been a variety of jurisdictions. And that makes corporations do; it affects jobs, prices, shifts in the balance of power within the the question of determining the scope of and practices elsewhere. And finally, corporation—from the autonomous their responsibility a lot harder. in this Internet era, corporations have corporate managers of the Berle and Complicating the issue is the fact access to so much information. In Means corporation to the independent that corporations are also political actors. turn, access to information fuels the directors, to shareholder activists, and Justice Strine’s latest article talks a lot demands that we impose on corpora- now, increasingly, to large institutional about corporate political activity. He and tions. As a society, we have the idea money managers. We might be worried I differ to a pretty big degree about the that, if you can find something out, if about these shifts because they essentially legitimacy of corporate political activity. you can identify a problem with your allow different stakeholders to have But we do agree that because corpora- suppliers or the living conditions in different amounts of say about what the tions are so big and global, they have a community in which you operate corporate purpose is. more political influence, and that influ- or the effect of your business on the But how do we reconcile differences ence is something to which we should environment, you have a responsibility among those different stakeholders? pay attention. to do something about it. How do we deal with questions of Corporations are subject to the competence and expertise? For many demands of an increasing number of Problems with Reframing years, academics argued for greater stakeholders—in addition to their Corporate “Purpose” to Address shareholder power as an antidote to shareholders—these stakeholders These Concerns managerial empire building and other include their employees, customers, These increased demands and types of agency costs. Colin’s book suppliers, creditors, and the expectations for today’s corporations follows this trend. According to Colin, communities in which they operate. present a lot of challenges. And so intermediaries such as asset managers, For a corporate officer or director, this our intuition is to reframe corporate mutual funds, pension funds, and variety of stakeholders and the varying purpose—to move away from other big institutional investors should interests that they have with respect to shareholder economic value as the sole be engaged in more active stewardship. the corporation’s operations raise the objective and instead have corporations But what do we mean by stewardship? question, “How do you balance the embrace a broader social purpose. That is Does that mean institutional investors different stakeholder interests?” My the premise behind Colin’s proposal. The are not supposed to focus on the view—and Marty Lipton and I share counter-narrative Colin defends would economic bottom line—which has this view—is that corporations and have corporate decision-making guided been the traditional way we expect corporate actors generally try to do the by a common purpose among corporate them to reduce agency costs? Does it right thing, both with respect to their stakeholders that Colin sees as more mean instead that they are somehow

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f it is difficult even to figure out what a rational shareholder I would prefer, how do we expect the average mutual fund to develop meaningful positions? And if we do not have a strong theory of rational preferences on the part of either the intermediary or its beneficiaries, what is our basis for challenging their current behavior? – Jill Fisch

responsible for compelling corporations shareholders say, “Look, we care about that are at the heart of this conference, to consider non-shareholder value? The the environment, and we want some for publicly pushing corporate manage- Department of Labor has instructed kind of balance between preserving ment to consider a counter-narrative. pension funds that they are not the environment and maximizing But my question is this: when Larry permitted to focus on non-economic corporate profit? If shareholder Fink writes a letter to the CEOs of the social welfare, that their job as value itself includes non-economic big public companies telling them that fiduciaries is to maximize the economic considerations, who makes that choice they must have a social purpose, who value of the fund in the interests of when the shareholder is an institutional is he speaking for? Is he speaking for their beneficiaries. intermediary?” Who gets to choose himself? Is he speaking for BlackRock? Even if the Department of Labor what those values are? Is he speaking for the shareholders in is wrong, can institutions play an When we talk about shareholder BlackRock’s mutual funds? And how effective role as stewards for society? power today, the new players are the do we decide what any of those constit- Commentators have recently begun big asset managers. Some people call uencies—who all have some degree of examining the behavior of the large BlackRock, State Street, and Vanguard power in this counter-narrative story— institutional investors who exercise the “Big Three” and we should how do we actually find out what they that power, and many have argued that probably add Fidelity to that list. But value and therefore how they seek they have inadequate information, asset managers aren’t shareholders, to hold corporations and corporate poor incentives, and agency problems they’re intermediaries that manage purpose accountable? Do we go to the of their own. pools of assets for the benefit of their people whose money is in the retire- This presents enough of a challenge customers or beneficiaries. How ment funds and say, “How much of a when the intermediary is tasked with does an intermediary decide what to hit on the return, on the size of your pot stewardship directed to maximizing do? Asset managers have their own of gold for retirement, are you willing economic value. But to the extent incentives, their own objectives. I don’t to take in favor of the environment, that stewardship means things that think we can reasonably expect them or water conservation, or the supply are unrelated to or even in conflict to operate their for-profit businesses chain?” with economic value, where do asset with the goal of maximizing social The agency problems stem, of managers get the insight into which of values. But do we truly understand course, from the fact that the large those things are important, and how their incentives and interests when they money managers are not owners but do they navigate the trade-off among engage in stewardship at their portfolio intermediaries; they exercise their power competing priorities? Indeed, even companies? on behalf of the economic interests of the concept of shareholder value is So, by way of example, Larry Fink the mutual fund beneficiaries, people problematic. Is shareholder value itself at BlackRock has received a lot of atten- that Jay Clayton refers to as “Mom and purely an economic concept, or can tion for addressing some of the topics Pop 401(k).” One debate I continue

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to have with Rob Jackson is that if we as those advocating greater board diver- the Columbia Business School, and a assume we could somehow finesse all of sity or better environmental policies. national expert on corporate gover- the technical issues that Ron Gilson is The challenge is that understanding nance and ethics. rightly worried about, and could actually a specific proposal and how it would find out how the workplace-only inves- impact the company is more complex Thoughts on Corporate Governance tors who have their money in Fidelity than one might think. It is arguably and Ethics—and the Role (and and BlackRock and Vanguard funds rational for a shareholder who supports Competence) of the State would vote on some of these shareholder board diversity to vote against a diver- Bruce Kogut: Thanks, Eric, for the kind proposals, would we then necessarily sity proposal when he or she thinks the words. And thanks to the Law School, want those votes to guide the decisions company already has a strong diver- and to Jeff Gordon and the Millstein that corporate executives and directors sity policy. It would be a mistake to Center for inviting me to take part in make? I’m not so sure. Some of my work treat all diversity proposals as equiva- this discussion. has focused on studying the financial lent, regardless of their specific terms. Jeff gave me a package of seven literacy of retail investors. First of all, it A shareholder may reasonably distin- or eight articles by Judge Strine a few is not very good. Second, when it comes guish between proposals advocating weeks ago, in the midst of a busy teach- to the subset of retail investors who greater gender diversity, racial diver- ing period, and I read most of them. I own a substantial proportion of mutual sity, and ideological diversity. If it is had read others by Judge Strine, and I’d fund shares—people I call “workplace- difficult even to figure out what a ratio- like to tell you a little of what I learned only investors” and who would likely nal shareholder would prefer, how do from this reading. be responsible for a lot of the votes by we expect the average mutual fund to Some of it has to do with my the big mutual funds—their financial develop meaningful positions? And if personal sense of the author that I get literacy is actually as bad or worse than we do not have a strong theory of ratio- from his writings. The judge is clearly a the average person who doesn’t own any nal preferences on the part of either the good man with a clear normative vision equity at all. intermediary or its beneficiaries, what of how the world ought to be. At the These limitations on the capacity is our basis for challenging their current same time, he’s also got a strong judicial of the so-called true economic owners behavior? pragmatism that governs his decision- to exercise shareholder power effec- In conclusion, I think the defense making. And as I read his work, he sees tively are potentially problematic. Now of the counter-narrative, the call for the law largely in conflict with these one can respond by arguing that finan- institutional investor stewardship, and norms. And I would think that’s a terri- cial literacy is a different and narrower a more expansive corporate purpose, is ble situation to be in unless I guess you’re skill set. Even if these investors do not appealing at a level of aspiration and made of strong stuff, which I suspect he understand compound interest, they theory. As with many reform propos- is. But as anyone who’s read his work know how they feel about important als, however, the devil is in the details. will tell you, Judge Strine also writes issues like corporate political spending, When it comes to practical guidelines with humor—which always helps—and executive compensation, and ESG. for decision-making by the big corpo- occasionally audacity. But I think that the kind of priorities rations that have such a pervasive But the Judge has got me nervous and policy choices inherent in these societal impact and the institutional because even in the business school, ever questions—questions with business investors who are being called upon since Bruce Greenwald started teaching ramifications—are quite complex. And to influence those corporations more, less, students have been sliding more investors are not being called upon to I think we have quite a bit of work yet and more in the direction of social- take abstract policy positions, but to to do. ism. And I’m concerned that eventually make these choices in the context of we’re all going to end up walking one concrete proposals. Talley: Thanks, Jill. And now Bruce after another underneath that Jacques Consider the issue of how mutual Kogut is going to seize the power Lipchitz statue on the plaza with a funds vote. Recently I’ve read some criti- chair. Bruce, as I said earlier, is the guillotine. No matter how good our cisms of mutual funds for not supporting Sanford C. Bernstein and Company hearts, we’re going to suffer for the sins sustainability shareholder proposals such Professor of Leadership and Ethics at revealed in our writings.

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At any rate, I’m not going to don’t always fit within the normal (And before I tell you why, let me also revisit the evidence for whether or not issues of board governance. But we also say that if you read Judge Strine’s article shareholder capitalism is bad. That’s a have to recognize the wider pressure on on inversions, you can really start to feel healthy debate that will continue for a intermediary fiduciaries like BlackRock the heat of his anger at corporations long, long time. I’d rather pick up what and others to respond to this growing that get a lot of subsidies—and then I understand is the underlying current concern among the population about want to run away.) here—namely, that there is something the environment, equality, and gender The way I read these cases, the terribly wrong about the distribution diversity and fairness that we now see important thing to recognize are of wealth in this country and other hitting boards and governance. For all the complementarities between countries. Because as the size of the boards, it’s quite a challenge to process the public sector and private sector economy and stock market have been all of these concerns, much less respond companies—the mutual benefits that going up, labor’s share of the economy, in a confident way. can come from a cooperative, but as the Judge pointed out, has been arm’s-length arrangement. There’s a set shrinking over time And those are the Toward a Coasian Bargain of mutual investments and cost-sharing things that have moved students, includ- between the Private and Public by private companies and the state— ing our business students. Sectors that is, by governments at all levels, But now let’s turn to the yin and But let’s take a step away from this local and state as well as federal. We yang of Judge Strine’s statements and board-centric view of governance, and like to talk about Coasian bargains take a look at some of his positions. look at the question from a broader between private parties, but there’s also Perhaps most surprising to many is his social perspective—one that I think a public Coasian bargain between the stated interpretation of the law that may be the only way to get out of this public sector and business about the corporate directors should not pursue problem. There was an interesting best, most pragmatic way of sharing of objectives outside of the sharehold- discussion in one of the Judge’s papers the joint costs as well as benefits that ers’ interest. And consistent with that about DuPont and the activist Trian result from the interaction of public position, Judge Strine also puts a lot of that I liked very much. In thinking and private activities. And, again, its emphasis on how corporate law limits about that case, I believe I understood important to recognize that there are what boards can do in furthering stake- that Judge Strine felt that DuPont not just negative externalities, but all holder interests. ended up getting too good of a deal— kinds of positive externalities from But however much I agree with both that after fighting and prevailing over this interaction of public and private. of those positions, I also think that we Trian and its demands, DuPont then And because of all these positive probably haven’t spent enough time turned to the state and said, “Subsidize externalities, it seems to me that there thinking about the powers that investors me, otherwise I will leave.” So, we’re left is lots of room for reaching a win-win have and what investors may want. This with the odd sense that after this fierce arrangement. Viewed in this way, is increasingly an interesting territory, governance contest beween DuPont DuPont’s tax subsidies may well prove the existence of a gap between boards’ and an activist investor that wanted to be a key part of what turns out to be objectives and what investors actually to break up the company and move a socially valuable bargain. are looking for. Along with competi- headquarters out of Wilmington, the To me, however, the big unresolved tive returns, large institutional investors corporation’s now going to ask for a issue here in this debate between show signs of a more active engagement subsidy from the state itself or else move the is and the ought that Leo Strine with companies in which they invest to from Wilmington. discusses in his papers is that we don’t monitor for compliance on a number of But however much I sympathize have a good positive theory of the social metrics, such as female directors with his unhappiness with DuPont role of the state—of what government on boards. for playing off the state and local does, and is supposed to do, to make From his comments this morning, communities against the activists, the private sector function not only we know that Ron Gilson is also skepti- I’m going to argue that Judge Strine’s more efficiently, but more fairly or cal about the ESG movement—and I framing of the problem is too narrow, humanely. This is why we have such an suspect that’s because ESG questions too critical of DuPont’s management. impoverished discussion of this issue in

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the U.S. and elsewhere. case is “more original than the original- if you will, you can see here that the For example, it seems to me that ists’.” In fact, after reading that, I told giving is very extreme. Now these are when you look at Mr. Cuomo this my students that “personhood” is not the same people who sit on the boards morning making his case for his in fact a really weird concept. Corpora- of the corporations that are dividing deal with Amazon, one of the really tions are people because contracts have their donations in the middle, and critical things that government does to be signed and corporations get sued these boards are acting in a bipartisan is to try and strike a bargain between and you need that concept. way. But when it comes to their own what corporations are going to do The debate inCitizens is really about personal giving, it’s quite extreme. They and what the states want to do, and “quid pro quo,” about acceptable levels go either to the left or the right; it’s not to find a win around that. And a lot and forms of influence, as well as the at all bipartisan. of that negotiating also happens at issue of First Amendment rights. And So, given that individuals tend to the community level, which I think then eventually we get to this bit about behave so differently than corporations, is extremely important to consider— corporate governance and whether this already tell us that maybe political namely the democratic voice of those companies should engage in political influence is not so much a corporate living in proximity to the new facilities activities that may go against the prefer- governance issue as an expression and how they are affected. Now in this ences of many shareholders. But what of the demands and preferences of area there’s also going to be non-state really surprises me about all these things the corporate elite themselves, what actors. There’s going to be civil society. is that I have no idea how much of this motivates them and who they actually And we can look at Amazon and say, activity—in a quantitative sense—has are. In a recent piece of research, we “Where the heck was the civil society to do with quid pro quo dealing or parti- showed that if you’re a director or a in this particular discussion?” But they san politicking. CEO after Citizens United, you are also play a role in this debate and are We know that corporations give most likely, if you are both rich and reportedly part of the explanation for money to corporate PACs. In 2016, ideological, to be giving a lot of money. why it failed. So, if you look at the wider it was about 6% of overall campaign That’s the top one. So it’s just rich, issues, the first level of governance in giving in the U.S. That’s probably knowledgeable people who really get terms of the ultimate social charter or because Citizens United kept it low. involved. And the good news for our license to operate, we need to decide Corporations don’t have the same research is that you can actually name what are the obligations of both parties liberty as individuals, since individuals them. There’s only a few hundred people to the social contract, the public as well are limited in how much money they who fall in this category, and they’re as the private sector. can give to corporate PACs, and giving a huge percentage of campaign corporate PACs are also limited in donations to the country—all of which Understanding Corporate how much they can give to political is completely outside of the original Political Activity campaigns. debate over the Citizens United case. Now I want to switch to the subject But there’s an interesting question So, based on our findings, the of campaign contributions, which Jeff here about where the money is really courts appear to have failed to focus on warned me not to go too deeply into coming from. And what our research the real action—which doesn’t appear because they are so fascinating, if not in fact shows is that the money to have much to do with a corporate very uplifting. We all get to see how is coming from individuals, not governance issue at all. What’s more, it much effort goes into being able to pay corporations. Corporations are much doesn’t appear to be a case of influence- more and more money to win friends more bipartisan than individuals in buying or corporate quid pro quo either. and influence people. Of course, the the sense that they are willing to give The main effect of these decisions has Supreme Court has made that easier in their money to incumbents, whether been just to increase the amount of the past few years—and I very much Republican or Democrat. They seem money that a few rich and ideological appreciated Judge Strine’s Harvard Law to be buying incumbents, regardless of individuals can give. And that’s why I’m Forum piece on corporate governance their policy positions. saying that this is ultimately an issue where he says that Scalia’s argument But for individuals who are either about income inequality and power, not on “originalism” in the Citizens United directors or CEOs, the corporate elite corporate governance.

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am not saying that unregulated blockchain is a great thing. I I’m saying it’s an expression of where we are right now in our economy when it comes to regulation: both on the left and the right, there’s this deep, deep distrust of the competence of the state. – Bruce Kogut

Co-Determination for first in order to have the work councils. by Vodafone, which already owned U.S. Companies? When I consulted my colleague Tom 34% of the company, of 125 billion Finally, Jeff asked me to say a few words Kochan at MIT, I thought he would euros, which was huge by European about Elizabeth Warren’s proposals be enthusiastic about getting a union or American standards. The deal got on corporate governance, especially into the VW plant; but he said that, caught up in a tangle of lawsuits, co-determination. I’ve long admired although it’s a great idea in theory, and the small payment that they had her work on bankruptcy and elsewhere, it won’t work unless you change the to give over to their unions became and her personal work as well.But in federal law. And that’s something else part of the complaint in the suits thinking about having significant that would be very difficult to do in the themselves. This kind of decision- representation of labor on boards, context of American politics. making was beyond their expertise I would argue that this imposition Now, when you look at given their life experiences compared requires a major step toward Europe the experience of labor and to the experience of their business and Germany in particular, where labor co-determination in Germany—and partners on the board. law and corporate governance law have I lived there for a few years—the So, I don’t think that co-deter- always been much closer together; it is work councils appear to work well. mination is going to be the issue that highly unlikely in this country where On the other hand, I don’t think Elizabeth Warren ends up focusing they tend to be separate. the research provides consistent on. And as we all know, you can’t just To give you some idea of the support for co-determination. Some pick off the menu what institutions difference, take the case of a recent studies suggest that it has some you want and think they’re going vote to unionize an auto plant benefits, but most say otherwise. to work somewhere else. Though in Tennessee that is owned by As one example, a case study of the I think she’s great, there is not a very Volkswagen. Volkswagen, which is Mannesman merger with Vodafone strong argument for labor representa- partly owned by a German state, did by our colleagues Kurt Millhaupt and tion on boards. But it represents the not oppose the union vote; but what Katharina Pistor showed that most background times we’re living in and it really wanted was to establish work of the labor representatives on the what people actually want to hear. councils at that plant. Such councils, board—and they’re supposed to make which are common in European and in up half under co-determination— What Blockchain Is a different form in Japanese plants, but had no prior experience in a complex Really Telling Us are not common in American plants, mega-transactions of this unsolicited One last comment—on schizophrenia. are believed to increase productivity. takeover. Partly for this reason, the It’s not something that’s unique to The problem for VW, though, UAW chose an ex-investment banker Judge Strine; we all have it. It’s the was that under U.S. law, management to be their representative to the GM conflict or tension, as I said earlier, cannot put a work council into a plant; board during the financial crisis. The between the is and the ought. that can be done only by the union issue the board was faced with was The subject came up interestingly itself. So, you have to have the union whether or not to accept an offer in the case of possible remedies, or

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reactions, to innovations that might be that doing something which is against you get to the top 1% that it’s even helpful. We had a recent seminar here the interests of the public and illegal close to true that most of people’s at the law school on blockchain, and is simply a cost of business. And since wealth is not derived from their own what the SEC should do about it. It it’s simply a cost of business, there is labor. The reality for basically 99% of was a great seminar, an amazing paper no ethical clout or stigma whatsoever people is that what you get to live on by David Hoffman and his colleagues. attached to such rules and fines. So, is attributable to your job. And so, for But because of the regulatory context, again, when regulations don’t make most people, what you get to invest is people forgot why we were talking sense to the regulated, it becomes also attributable to your job. And let about blockchain in the first place. simply a cost of doing business. me just mention that the Coalition for A decade ago, we had a nuclear At any rate, I am not saying that Inclusive Capitalism is working with meltdown of the financial system unregulated blockchain is a great thing. leading accounting firms to try to look in this city, with lots of people put out I’m saying it’s an expression of where at ways that investments in human of jobs. And among some populations we are right now in our economy when capital can be rebalanced. here, it may amaze you to know that it comes to regulation: both on the left Now these are proposals for there are still many who are pissed and the right, there’s this deep, deep incremental change. I am not a off about that particular event distrust of the competence of the state. revolutionary. But part of what we should and what they actually had to go And we’re being hurt by that because always remember is that we haven’t had through—and the people feeling this the state is so often a necessary partner a revolution in this country because we way are well represented on both the to what we want to get done. have always been able to evolve—we’ve left and the right. Now, having said all that, I don’t adapted in different dimensions. So along comes blockchain, this know if I have saved us all from the One way I see to improve things so-called autonomous, decentralized guillotine. But if not, don’t worry; I’ll is through better shareholder voting on technology that allows people to be right there with Judge Strine and proxies. Ron Gilson and Jeff Gordon bypass the government in order to colleagues, until we narrow the gap have a good paper—in fact, it’s the one do these transactions. Some of these between the ought and is. that Rob Jackson just mentioned at the transactions are illegal; a lot of the Thank you very much. end of his presentation—about the role initial coin offerings are “soft junk,” of large institutional investors in voting and there’s more than the usual amount Talley: Thanks, Bruce. I’m now going on and sort of refereeing the proposals of hype. But over the time, we are likely to invite Chief Justice Strine back up put forward by shareholder activists. to find some tremendous successes to the power seat to respond to the last Well, that kind of voting is something that offer people a way to bypass the three panelists. that, as Jill can tell you, I’ve been talking government as well as the SEC. about for 15 years. And I’m really glad But the irony of all this—what The Judge Responds to hear that the Big Four—and they are really struck me about this seminar— Strine: I just have a couple responses. now four, because I think Fidelity just was that the only topic of discussion One part of Mark’s presentation that passed State Street in indexing—are in the room was how much good the got my attention is that corporations making better use of their vote. SEC could bring to this problem of are now sitting on plenty of cash. Why But at the same time, Mark, the regulation of blockchain—because hasn’t some of that cash gone to the studies also show that the gains from there’s so much fraud going on. Why, workers? Could it be because the stock activism also involve transfers from I kept thinking to myself, weren’t we market opposed that use of capital? workers and from debt holders to also asking these representatives of the On the question of shareholder equity. And debt doesn’t get much of SEC other questions, such as: “What activism, I’m not actually against it; a say until it’s in distress. So, we need did the SEC regulators do during if you read my writings, I talk about to try to limit or at least compensate the financial crisis, except to put so some rebalancing of power between people for these transfers. many rules and fines on the banking shareholders and boards. And I also On the political side and industry of America and elsewhere that point out some basic facts about vote-buying, I agree with Bruce’s now every banker in the world thinks wealth distribution. It’s only when point that it’s as much a problem of

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individuals as corporations. But the And I think that’s what we now Talley: Thanks, Leo. And thanks to tendency of corporate donations to be all have to talk about, about how we all the panelists for taking part in this bipartisan should not hearten you for get from here to where we want to be. discussion. this reason. Corporations are giving to For example, Mark, if we want say on people who influence their businesses. pay votes, wouldn’t it make more sense Democrats and Republicans alike are that we have them every four years beholden to interests who give them instead of every year, and that they money, and on regulatory policy that’s actually be thoughtful? If someone’s important to politicians of both sides; running a hedge fund campaign and they will go with the people that give they’re planning to make an important them money. Democrats get money change in the business that could take from lawyers and from hedge funds 10 to 20 years to pay off, shouldn’t the to accomplish the same things that investors voting in that campaign be Republicans do. told that the fund itself has to wrap I also think we don’t know a lot up in three years, and so it actually about corporate money. But we do can’t stay invested longer than that? know that even before Citizens United, Shouldn’t the voters have that kind of labor and environment groups were far information when they know all the outgunned by business. The reason other things about what’s going on why, of course, is that if labor had inside the companies? more money, they would be what class? So, again, I think there are a lot They would be capital. The tilting of of incremental things that we can do the playing field in terms of the rules to make things better. But, in terms of the game has gotten worse. And by of the ESG movement and everything the way, some of those individuals look we have to do, I think we ought to be much more like corporations. Much of very careful not to forget, or confuse, the spending by the U.S. Chamber of what the Securities Acts were about. It’s Commerce and other groups, which important that everyone understand has gone up a lot, actually comes from what corporations do—both what corporations and it’s not disclosed. they are supposed to do for society, Now, as for the question of and what they are not supposed to schizophrenia, I’ve never understood do. That’s something everyone should psychiatrically whether that’s having know, whether they own publicly listed two different identities, or some other securities or not. disorder. But whatever I have, I don’t As for the Warren bill, I think think it involves any confusion between one of the things Senator Warren did is and ought. I have a very strong view that was absolutely right was to make of what ought to be. My view, which is it apply equally to private as well as consistent with that of Berle, Orwell, public companies. I worry that if we Roosevelt, and other clear-eyed people, make just public companies make ESG is that if you want to get to ought, you disclosures, it will have the perverse have to understand is and how is has to effect of narrowing our prism on the be changed to get to ought. If wishes economy because more companies were horses, I could ride away down will simply go private. The size of past Penn Station and all the way home the economy that we don’t have any to Delaware without anybody getting window on will increase, and that’s in my way. not what we want. And I’ll stop at that.

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SESSION V: MACRO PERSPECTIVES: BIGGER PROBLEMS THAN CORPORATE GOVERNANCE

Columbia Law School | New York City | March 1, 2019

Bruce Greenwald Edmund Phelps Robert Heilbrunn Winner of the 2006 Nobel Professorship of Finance and Prize in Economics, and the Asset Management at the Director of the Center on Columbia Business School; Capitalism and Society at Aademic Director of the Columbia University Heilbrunn Center for Graham & Dodd Investing. Photo Copyight: Mike Dames, [email protected] Joshua Mitts Professor of Law, Columbia Law School

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Joshua Mitts: Good afternoon, I’m Work, than less tangible satisfactions, This tells you something very Josh Mitts, a second-year professor here such as the psychic rewards that come important about the limits of what at Columbia Law School, and I have the from total engagement in projects, and can be accomplished through effective great pleasure of introducing our next the successes—and prosperity—that corporate governance alone. Whereas two speakers. sometimes come with it. His latest book, technological and structural economic We will hear first from Bruce Green- Mass Flourishing views the experience of change tends to be global, corpo- wald, who holds the Robert Heilbrunn discovery on an unfolding voyage as an rate arrangements tend to be local or Professorship of Finance and Asset extended metaphor for the economic national. That suggests to me that we’re Management at the Columbia Business progress of the race. And as the book not going to solve this global problem School and is the academic director of the begins by observing that, although even with a local solution. So, let me start Heilbrunn Center for Graham & Dodd cavemen had the ability to imagine new by saying that the solution does not lie Investing. Described by the New York things and the desire to want to create in new or better corporate governance; Times as “a guru to Wall Street’s gurus,” them, it took a human culture intent on governance is not the problem here. The Bruce is an authority on value investing, liberating and inspiring the dynamism problem is a global economic transition; with considerable expertise in productiv- that would ignite a passion for the new and by fiddling with corporate gover- ity and the economics of information. to bring about such innovation and nance in individual countries, where He has been recognized many times for progress. different governance regimes work his outstanding teaching abilities as the It’s hard to think of a more fitting with different degrees of effectiveness recipient of numerous awards, including end to our day than these perspectives in different social contexts, we’re much the Columbia University Presidential that we’re now going to gain. And with more likely to make things worse than Teaching Award. His classes are consis- that, I’m going to turn it over to Bruce better. There are much more useful tools tently oversubscribed, with more than to get us started. to use in this transition than governance 650 business school and non-business reform. So, from the point of view of the school students taking his courses every Global Economic Dislocation: topic of this conference, my talk will be year in subjects that include value invest- Causes and Consequences a disappointment. ing, the economics of strategic behavior, Bruce Greenwald: I’m going to start by I want to start by talking about the globalization of markets, and strategic responding to something that Mark Roe economic dislocations in an histori- management of media. said earlier—namely, that today’s prob- cal context. The dislocations I will be After Bruce, we’re going to hear lems and challenges have a lot more to talking about are quite different from from Edmund Phelps, winner of the do with things going on around the ordinary business cycles, which are 2006 Nobel Prize in Economics, and world that are well beyond the scope of invariably self-correcting and consist of the director of the Center on Capitalism corporate management and governance short, sharp contractions followed by and Society here at Columbia. Edmund than with corporate governance itself. much longer, restorative expansions. The has written quite a number of books, on The challenges are associated with what situations I will address are generally not subjects such as growth, unemployment I would describe as a global economic self-correcting; they involve extended theory, recessions, inclusion, rewarding dislocation. periods of bad economic performance work, dynamism, and innovation. His First of all, I think it’s clear that and disappointing recoveries. Fortu- work can be seen as a lifelong project unhappiness with economic perfor- nately, they are also rare. In modern to put people as we know them into mance is now a global phenomenon. I’ve economic times, there have been only economic theory. His most recent work just come back from living in Paris for two, the Great Depression and the is an attempt to provide economics with four months and from visiting Japan for developments associated with the 2008 a new foundation of Renaissance, or the first time. Whether you are talking financial crisis, many of which surfaced “individualistic,” values. In this view, about Northern or Southern Europe, well before 2008 and persist today. innovation is identified as the primary Japan during the last 25 years, or the Both situations are associated with the driver behind the accomplishments and United States, there is a widespread sense transformative demise of an economi- prosperity of the advanced economies. that the global economy is not working cally and socially important sector of the Higher income and wealth matter less, well. Even in China these days, there global economy; it was agriculture in the as he argues in his book, Rewarding seem to be emerging tensions. 1930s, and it’s manufacturing today.

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hus, the difference between the current situation and that T of the 1930s and 1940s is that we must manage a transi- tion to a place that is not a happy destination. What’s more, this is a global problem. And it is such a difficult problem because we have to do something about both productivity growth and the distribution of income. – Bruce Greenwald

In both cases, there are issues associ- The Depression worked nothing longer finance their movement to the ated with managing the transition and like this. The second half of 1929 was cities and preparation for industrial with the consequences of the post- bad; 1930 was worse; 1931 was terrible; jobs. Net outmigration from agricul- transformative economy. In neither case and 1932 and early 1933 were also bad. ture in 1929-1932 fell to zero. Farmers are there “bad actors” whose behavior This is a very long, continuous contrac- stayed on their farms where rising could have been “corrected.” Agricul- tion. It was followed by an unusually productivity enabled them to increase ture died because long-term agricultural slow recovery which, in the U.S., was the supply of agricultural goods. The productivity growth, then at roughly interrupted by a sharp recession in increase in supply in the face of inelas- 5% per year, far outstripped growth in 1937-38. Some countries never fully tic demand further reduced prices and the demand for agricultural products, recovered from the Depression. Argen- farm incomes, which in turn increased which was perhaps only 2% per year. tina, for example, was a fully developed the difficulty of financing outmigration Manufacturing has been dying and will economy through the 1920s and had a to the industrial sector. The result was continue to die for the same reason. standard of living not far below that of a downward spiral that reduced U.S. Manufacturing productivity growth the U.S. But after 1929-1932, it fell far farm incomes by fully 80% between is far higher than global growth in the behind the North. 1929 and 1932. demand for manufactured products. The heart of the problem during the Given that roughly one third of Given these underlying forces, these painful years between 1929 and 1933 the U.S. population in the early 1930s situations will not be significantly was the difficulty of moving increas- was dependent on agriculture, this improved by changes in discretionary ingly unnecessary farm workers out of 80% income decline had a catastrophic corporate behavior. rural agricultural jobs into urban indus- impact on the demand for industrial trial ones. The years from 1900 to 1920 goods, bringing the overall economy The Role of Agriculture in were prosperous ones for agriculture. As down with the farm sector. Even if The Great Depression: a result, when farm prices fell sharply, as farmers had been able to move, there How Productivity Gains Lead they did in 1920-1921, marginal farmers were thus no industrial jobs available. to Falling Prices and Massive had the wealth necessary to finance The decline in the overall economy was Overcapacity their own movement to urban areas and then amplified by the financial conse- To illustrate the nature of these global retraining for industrial jobs. quences for businesses of falling sales economic dislocations, it will be instruc- During this episode, the historical and incomes relative to existing debt tive to look first at the Depression, data show major farm out-migration levels. Overleveraged balance sheets because we know how that worked out, during the farm recession years. Over forced sharp reductions in investment, and then look at where we are today. the course of the 1920s, however, employment, and output—so-called Recall that a normal business cycle typi- continuously low prices undermined “debt-deflation effects.” And much the cally consists of a six-to-nine month the financial position of farmers. When same developments took place around contraction followed by three years or farm prices fell sharply in the summer the world, mirroring the U.S. pattern more of healthy recovery. of 1929, marginal farmers could no and creating a global depression.

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The policy response to those diffi- The Solution: World War II and the ual workers. Thus, industrial wages are culties reflected many of the actions Relocation and Industrialization of heavily dependent on average—not being taken today. Governments’ the Work Force individual—productivity, which led to first instincts were to try to solve the Without the demand stimulus provided a significant flattening in the post-war problem of surplus farm production by by World War II, it is not clear how the distribution of income. increasing exports. For example, big Depression would have ended. However, Third and finally, industrial agricultural producers like Argentina even that would not have been enough goods—like farm products but unlike and Australia devalued their currencies except for a second unremembered, services (an important difference as in the face of falling farm prices in the but critical aspect of the War effort. we shall see)—tend to be sold in large summer of 1929—and thus before the Keynesian economists in Washington global markets. Because these markets 1929 stock market crash—or in early and Europe were certain that, as war- are too big to be dominated by any small 1930. Each individual devaluation led related production demand disappeared, number of firms, they have always been to increased exports—and reduced the Depression would return. Fortu- highly and increasingly competitive. imports—which helped stabilize both nately, this did not happen. World War Thus, the post-war period saw no signif- agricultural and overall economic II had the global effect of moving huge icant increase in profits at the expense activity. But, collectively, these efforts numbers of people off the farm into the of wages—if anything, the relative share were doomed to failure. The global industrial sector at government expense, of profits declined over time. The result sum of all net exports must be zero. either directly or with an intermediate was unprecedentedly rapid growth in What one country exports, another step in the armed forces. World War post-war wages that tracked the rapid country must import. When the U.S. II, except for countries like Argentina growth in productivity. In moving and other producer nations responded that did not participate, inadvertently from agriculture to manufacturing, the with high tariffs and their own devalu- achieved exactly the labor force reloca- transition was difficult but the post- ations, any initial beneficial change in tion that was essential to the structural transition economic environment was demand evaporated. Further reactions transformation of the global economy. highly desirable. by still other countries only spread the Once that transition had taken problem. The final result was global place, three aspects of the industrial The Long, Slow Death of deflationary pressure, as countries economy created a highly favorable Manufacturing—and the Global sought to reduce their export prices economic environment, leading to Financial Crisis and discourage imports, with no net several decades of unprecedentedly high The current transition from manufac- benefit and the overall depressing effect growth and prosperity. First, in contrast turing to services has been less difficult of the trade wars that we are likely to to decentralized farm production, than the shift from agriculture to experience again today. industrial facilities are large and central- manufacturing since there is much less Other New Deal programs, like the ized. Big factories can support large geographic relocation involved. But AAA, which were designed to reduce numbers of managers, engineers, and the destination is far less attractive. farm production and, ideally, raise other technical resources concentrated Still, the transition has been slow and farm prices were equally unsuccessful. on generating continuous productiv- painful. Just as the decline of agricul- As long as 35% of the U.S. population ity growth. These efforts benefit from ture involved the elimination of jobs remained unproductively in agricul- economies of scale and the cumulative with significant economic and social tural production—now under AAA effect of a stable institutional base. In value—think of the “yeoman farmers” crop limitation programs, and produc- the U.S., Western Europe, the British of Thomas Jefferson’s ideal republic— ing less than before—the economy was Dominions, and Japan, war productivity the demise of manufacturing has taken unlikely to recover. Moreover, reduc- growth occurred at the highest observed place in the context of a powerful tions in U.S. domestic production were levels in economic history. commitment to sustaining manufactur- generally offset by the impact of higher Second, workers in these large insti- ing jobs, with its imperative of actually prices on global output. tutions tend to operate collectively with “making things.” There is a large global relatively narrowly defined individual population of manufacturing workers jobs. In this context, it is hard to identify whose human capital will be destroyed and reward the contributions of individ- in the process. Many individual coun-

Journal of Applied Corporate Finance • Volume 31 Number 3 Summer 2019 67 ROUNDTABLE tries have particularly strong national deficits. But the borrowing of foreign United States. Today, it grows about commitments to manufacturing. currency necessary to finance these ½% per year more slowly. The standard In Germany, specialized manufac- deficits undermined confidence in explanation for this change is demogra- turing firms have been models for their currencies. This in turn led to phy and deficient demand—attributed German economic success. They and the collapse of local currency values mainly to the widespread existence of their associated unions have enormous (during the Asia Crisis of 1997-1998), “zombie” firms and banks in the wake political power. Japan has regarded reduced abilities to service foreign of the 1990 crisis. Both factors should itself as a resource-poor country whose currency debts, widespread bankrupt- operate by reducing both the supply resource imports are essential to national cies, and deep, long-lived contractions. of and demand for Japanese labor, as survival. As a result, the Japanese have Since then, however, declines of measured by hours worked. But this always sought to have a large margin of 50% or more in the values of these cannot be the explanation for the dete- safety of exports over imports. Because currencies have moved their trade rioration in Japan’s growth rate relative exports have of necessity consisted largely and current account positions from to that of the U.S. of manufactures, Japan has developed a deficits to surpluses—surpluses that, Whereas Japanese hours worked focused expertise in manufacturing; and given their unhappy experience with pre-1990 grew 1.5% per year more Japanese manufacturing productivity deficits, they have worked very hard slowly than U.S. hours worked, has historically exceeded U.S. manufac- to maintain. The problem with all this Japanese hours worked since 1990 have turing productivity by 30%. And like “neo-mercantilism,” as Jeff Gordon grown only 1.4% more slowly than Germany, Japan has a politically and called it, is that other countries have to U.S. hours worked, which is a slight socially dominant manufacturing sector. “eat” both the existing surpluses as well improvement in relative growth. The More recently, China has pursued an as these new ones. Ultimately, the U.S. decline in relative performance can export-led growth strategy built around and a handful of other countries have thus be explained only by the decline manufacturing production that has so become the importers or consumers “of in Japanese productivity growth relative far been a critical source of domestic last resort.” But their leakage in spend- to U.S. productivity—as measured by income and employment for workers ing overseas has meant that the deficit output per hour worked—from a 3% migrating from rural areas. countries suffer from chronic deflation- annual Japanese advantage before 1990 And just as during the Depression ary pressure, which leads to reduced to a ½% annual U.S. advantage today. countries sought to sustain their agricul- demand growth throughout the global This is the result of an increasing misal- tural sector with international trade economy. With no sign that the surplus location of human and other resources surpluses, China, Japan and other Asian countries are willing to abandon their by an otherwise extraordinarily effec- countries have sought for the past 30 surpluses and shrink their manufac- tive business-government productivity years to do the same for manufacturing. turing employment, this deflationary machine to ever diminishing manufac- They have all run large and persistent pressure and the associated slow rate turing employment. trade and current account surpluses of global growth is unlikely to end any Similar problems have affected other using a combination of exchange rate time soon. G7 countries. Since 2000 U.S. produc- controls—in the case of Germany, by tivity growth has been the highest in the adopting the Euro, which has eliminated Global Productivity Problems in G7, for the first time since World War the effects of the formerly rapid appre- Manufacturing II. Overall, however, G7 productivity ciation of the mark—trade barriers, and Moreover, as manufacturing coun- and wage growth rates have fallen well direct subsidization of manufacturing tries like Japan and Germany direct below the thirty-year average rates of the firms—as in the case of Airbus. their managerial, technical, and capi- post-war period, and there is unlikely to But given the zero net surplus tal resources to a shrinking and be any improvement any time soon. The nature of international trade, these ultimately dying sector, overall rates of overall difficulties of transitioning to a strategies are no more sustain- productivity growth will suffer, further service economy—slow demand and able today than they were in the undermining global growth. The case productivity growth—while less severe Depression. Countries like Korea, of Japan is instructive here. Before than in the Depression, are likely to be Malaysia, Indonesia, and Thailand 1990 Japan’s economy grew about 3% with us for a long time. once ran significant current account per year more rapidly than that of the A further aspect of the transitional

68 Journal of Applied Corporate Finance • Volume 31 Number 3 Summer 2019 ROUNDTABLE global regime of slow growth and played a major role in the financial Identifying the contributions of individ- stagnant productivity increases should market dislocations of 2007-2008, the ual workers is hard, and wage differences be mentioned. The vast increase in global financial crisis itself can be seen therefore are relatively small. At the manufacturing capacity in China and as one fairly direct consequence of the same time, the U.S. economy employs East Asia has exacerbated the problem demise of manufacturing. 260,000 professional athletes, coaches, of declining manufacturing employment and referees. These workers’ individual in the developed world. But this is a The Outlook for a Global Service performances are considerably easier to secondary part of the story. Technology- Economy: Low Productivity and identify and distinguish; and, as a result, driven productivity growth has always More Inequality they receive vastly different paychecks. played a larger role in manufacturing What’s more, the service economy Movement from industry to services job loss than exports, whether from toward which the world is headed, and has led—and will continue to lead—to China or elsewhere. In 1992, when at which the U.S. has largely arrived, has greatly increased income inequality. Presidential candidate Ross Perot talked three characteristics that make it much Third, services tend to be locally about “the giant sucking sounds of jobs less attractive than the industrial world produced and consumed. Local service going to Mexico,” only 15% of the U.S. we are leaving behind. markets are relatively small and can manufacturing jobs lost during the First, and perhaps most important, be dominated by single firms or small previous 11 years were lost to imports; service institutions, like farms, tend to numbers of firms; think of a one-store or the other 85% were lost because of be small and decentralized. Increasing a two-store town. These dominant firms advances in technology. Today those productivity across many stores, schools, benefit from scale-related competitive numbers are one third due to globaliza- doctor’s offices, or restaurants is much advantages that enable them to control tion, two thirds to technology. harder to achieve than productivity competition and earn supernormal Finally, the structural trade imbal- growth at a single large factory. In the profits. Profits in a service economy ances associated with the desire to U.S., there are some large service compa- receive a generally greater share of preserve manufacturing jobs have had nies like Wal-Mart or McDonalds that national income—relative to wages— significant negative financial market have managed to do this. In Europe, than in an industrial economy with consequences. [continue PP] Japan, and other East Asian countries, robust competition. Between the late When the U.S. runs a deficit of few such firms exist. Slower productivity 1980s and today, the share of profits in $600 billion a year with China and growth will almost certainly be a feature the U.S. national income has increased Germany, their $600 billion surplus of a service economy once manufactur- from about 8.5% to more than 14%. must sooner or later be invested in ing has been reduced to the status of And this is not related to higher levels the United States. Foreign money is agriculture. At the moment, the U.S. of investment. Business investment as a almost always uninformed money, has an advantage in this area; and since share of U.S. national output has fallen and so there is $600 billion in fresh, 2000, as I mentioned, it has enjoyed the over the same time period. relatively unsophisticated, demand highest productivity growth among the A service economy will therefore for new Wall Street products. The G7 economies. But even U.S. productiv- grow relatively slowly and with increas- surplus countries started out investing ity growth is well below that of earlier ing income inequality and wages their surpluses safely in U.S. govern- post-war levels. suffering relative to profits. By most ment instruments, which helped drive Second, service workers tend to standards, this is not going to be a down U.S. interest rates. When they operate individually rather than collec- happy outcome and, given the struc- indicated they were not happy with tively. To illustrate what this will mean, tural factors at work, is not going to low rates, Wall Street provided them consider the differences between service be improved through better corporate with higher yielding mortgage-backed and industrial jobs today. To cite one governance. securities. The relatively high default example, the U.S. economy today has Thus, the difference between the rates on these securities was one of the 140,000 non-professional extractive current situation and that of the 1930s triggering mechanisms for the financial workers—coal and other miners, oil and 1940s is that we must manage a crisis. And, to the extent the decline of platform workers, and so forth. Mines transition to a place that is not a happy manufacturing led to the international and oil platforms are big facilities in destination. What’s more, this is a global payments imbalances that in turn which workers necessarily work together. problem. And it is such a difficult problem

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ore broadly I would argue that operating on the economy is M not a solution. It’s necessary to restore to the people the good values that once brought rapid economic growth and thus the good life and, perhaps, to extirpate the values that obstruct economic growth. If we do that, we can hope to see rapid growth again. – Edmund Phelps because we have to do something about lating to hear Bruce Greenwald expound growth slowed down? In my book, Mass both productivity growth and the distri- for us his latest ideas on the downturn. Flourishing, I cited a large set of develop- bution of income. I think I’m a better ments, social as well as economic, that Marxist than anybody else in this room, Greenwald: Mine and Joe Stiglitz’s. in my opinion help to explain the great but you don’t want governments futzing productivity slowdown of the Ameri- around with this one. You want to have a Phelps: Yes, yours and Joe’s. can economy. As just one possibility, I massive earned income tax credit, which Bruce speaks of economic perfor- pointed to CEOs whose retirement pay is governed by fixed long-term rules that mance as having three elements: growth, would suffer heavy losses if their corpo- are universally applied. distribution, and job satisfaction. And I ration undertook a venture that failed. This is preferable to a non-work- think that’s kind of a convenient way to Like this one, most of my hypoth- related governmental national income. organize things. eses are instances of my general thesis If you have a guaranteed national And when talking about the causes that innovation is a major contribu- income, many people who work are of the decline, he speaks about the advan- tor to economic growth and what going to be really pissed off, as they tages of collective work over individual I call “economic performance.” By are now in Europe by all their retirees. work, about fewer jobs for strong-back economic performance I mean job Also, we are going to need institu- labor, and about monopolies sprouting satisfaction, participation, and a variety tions to improve productivity growth up. As for corporate governance—which of non-material “modern values” that in services, maybe the way the U.S. is the principle topic of this meeting, I argue are essential contributors to Agricultural Extension Service did in and a major cause of the economic productivity and prosperity. the agricultural sector. This is going to problems in the minds of many people And my contention is that if this be a long, difficult process. My concern here—Bruce is skeptical that corporate nation of ours still had the right values, is that if you distract businesses from governance has gotten any worse. we would be having rapid growth and making this transition by mandating But, I don’t think Bruce’s long- high job satisfaction. things that interfere with manage- cycle argument really explains why the Now this leads straight to a couple ment’s efforts to increase productivity, economy has been driven off the rails. of themes of my work. First, there are you’re going to make these very pressing I don’t see the causation? Bruce says likely to be ways to repair some malfunc- problems even worse. manufacturing employment is dying, tions in the economy that play some Mitts: Thanks, Bruce. Now let’s hear but I’d like to hear more about why it’s part in the slowdown. For example, the from Edmund Phelps. dying. What is new about competition government could get serious about low from abroad? There were eras in which wage employment subsidies in order to Other Contributors to the U.S. the United States had plenty of competi- pull up participation rates and wage Productivity Problem: Failure of tion from abroad. rates at the low end. The government Values Clearly, productivity growth might cut tax rates on corporate profits, Edmund Phelps: Well, it’s a great matters, but I thought that’s what we’re in the belief that such cuts would induce pleasure to be here, and it’s always stimu- here to explain: Why has productivity increased business investment.

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I favor low wage subsidies; but as rates, which are a pretty good proxy for that focusing on such solutions will only an economist, I have to say that such the rate of return to investment, have distract us from the important structural employment subsidies are only a one-off fallen from two or three percent decades issues. Do you agree with that? measure that might double wage rates at ago into what looks like negative terri- Phelps: I think I agree with it, but the very bottom of the wage scale. But tory now. Finally, and very important, Bruce’s basket of structural factors are that’s no match for the rapid growth that data show that reported job satisfaction different from my basket. we used to have, which doubled wage has declined appreciably since the data My basket is all about individualism rates every 24 years, for a very long started in 1972. from the Renaissance. From Cervantes, period of time. Corporate tax cuts may I don’t think it’s been adequately Shakespeare, and onward, there’s a rich well stimulate business for a while, but recognized how absolutely extraordi- palette of values that came bubbling up such effects cannot be permanent, owing nary this decline has been. One would in the west. But it’s run into competi- to the law of diminishing returns. Even have to go back, perhaps, to Britain in tion with a lot of antithetical, collectivist if you keep on investing, and piling ever the 1960s and ’70s, or even the Weimar kinds of values that don’t prize individ- more capital into the economy, if you Republic from 1918 to 1933, for a ualism, don’t prize experimentation, don’t have any innovation to provide comparable decline in the West. With discovery, exploration. In the four or improving techniques, you’re going to this background, I think it is clear that five years when I was writingMass Flour- run into diminishing returns. As any the people who saw their wage rates ishing, everything I saw resonated with good elementary economics textbooks stagnate, or at least fail to go up with the what I was writing at that time. I don’t will tell you, it’s not just labor that runs incomes of others, feel considerable pain think the situation has changed much. into diminishing returns on a fixed plot and embarrassment. The great economist of land; capital runs into diminishing Adam Smith and the great philosopher Greenwald: I think it’s all these other returns when limited to use of a fixed John Rawls would have agreed. things have to change, not corporate set of people and technologies. I think that these people also feel governance. More broadly I would argue that frustrated that their many years of hard operating on the economy is not a work have not brought them appreciable Gordon: Let me just add a kind of solution. It’s necessary to restore to wage gains in an absolute sense, regardless editor’s note. Many of us here are gover- the people the good values that once of what others are now earning. So it’s a nance specialists. We have to figure out brought rapid economic growth and double whammy. Two things are going what governance can do, what it can’t thus the good life and, perhaps, to extir- on that are very serious. Had western do; and other places where maybe we pate the values that obstruct economic societies not been hit by the severe should be looking. Colin, do you have growth. If we do that, we can hope to see economic decline, it seems unlikely a thought here? rapid growth again. that these members of the working class Another theme of mine has to would have been so angry. Had they Colin Mayer: Edmund’s perspective do with the social strife that seems to been getting ahead, they would not have places a lot of emphasis on values, one of have come with the economic decline been so put out by the success of others. the issues that underlies this conference. in the west, particularly in the U.S., So we need to find ways to restore Should the values of modern society be the U.K., and France. Take the discon- innovation, not only for the economic focused purely, or so heavily, on financial tent expressed by the gilets jaunes—the growth and even the job satisfaction returns? In that regard, what Edmund yellow vests––in France, and by the it could be expected to generate, but has just been talking about is absolutely working class in rural America oppos- also for the restoration of wage growth central to the debate that we’ve been ing immigration, and the northerners in among others who would experience having. Britain favoring exit from the EU. What no wage growth at all for some time. accounts for these feelings? Thank you. Greenwald: Productivity growth is In the U.S. the growth of real the fruit of what you’re talking about. average labor compensation per worker Questions & Answers But I think it’s important to recog- has slowed from two to three percent Jeff Gordon: Edmund, Bruce told us nize that most productivity gains don’t per annum in the 1960s to around one that firm-level governance solutions come from movements in the produc- percent or less since 2005. Real interest are not likely to advance the cause, and tion possibility frontier, but rather

Journal of Applied Corporate Finance • Volume 31 Number 3 Summer 2019 71 ROUNDTABLE from movements within and toward individuals, not organizations. It starts Hunter Harrison. the frontier. The most efficient firm with the personal computer—and then So, to be successful, corporate in an industry—even in an industry the Internet. What an individual can governance regimes must take advan- with essentially the same labor force, do now with those innovative things tage of the power of specialization and the same level of capital, and seasoned is extraordinary compared to what you the power of culture or you’re not going technology—tends to have a cost could do in the days when you had to to get the sort of thing that Edmund is structure that is a third to a half of the go to the library to collect data. You talking about. industry average. can do in minutes what took weeks So, if you look at the process of before. Alan Schwartz: I think that Bruce’s productivity growth at the individ- This will exacerbate the differences suggestion about an expanded earned ual company level, it all comes from in ability between individuals. The income tax credit is something we know movements to that frontier; not in successful societies, I think, are the how to do; because we’ve had it, and movements in the frontier. That is ones where those individual differences we can expand it. In a way it’s easy to a managerial function. And if you get attenuated rather than exaggerated. follow Bruce’s concrete suggestion, but, distract managements from the kind Unfortunately, this is a global problem Edmund, how do I make concrete your of innovation that produces these not just a U.S. problem. The services high-level analysis, even if I’m persuaded productivity gains, I think you’re going transition is really global; it’s going on by it? to forfeit all the beneficial things that everywhere; and countries that haven’t Edmund is talking about. done it have suffered much more in Phelps: Well, people who had contrary productivity growth, by the way, than values were able to promulgate those Unidentified Observer: Mr. Phelps, you the United States. But technology is values rather effectively. So why can’t we mentioned the need for innovation to going that direction, too. I don’t know get back to the earlier values? I think it’s help the American worker, especially the how you’re going to stop that with almost a case where wanting something workers whose wages are currently stag- corporate governance. is half of the battle. We can change the nant. I think there’s at least a plausible It is the corporate and the national school system so that it celebrates adven- argument that innovation, particularly cultures that Edmund is talking about ture, creation, imagination, exploration, in the tech sector, is actually a driver of that are far more important than the discovery, night and day, all the time. In income inequality. So can you elaborate specific rules of governance. I’ll say a couple of decades I would think that a little bit on how you see innovation that in slightly different terms. Progress would be felt in society and reflected in helping those workers whose wages are comes from specialization. The problem the economy. currently stagnant? with boards of directors is that they’re not specialized. Gilson: I want to come back to Bruce’s Phelps: I think you are touching on the And the problem with a lot of most recent comment that two thirds of point that not all innovations are homo- these shareholder activists, or interven- the companies in a particular industry geneous and beneficial to all workers. I ers, is that not nearly enough of them are badly managed. Are there mech- agree that the future is unknown, and are specialized. When you see a highly anisms that may cause the other two so we can’t be entirely confident that specialized intervener, like Paul Hilal, thirds to accomplish something they innovations will make a difference for who made such a difference at Canadian have the capacity to do but, for some the better for most people. It’s too bad, Pacific, the results are extraordinary; reason, aren’t doing it? but it’s the way the world is. I do feel but that’s not something that corporate confident, though, that if we don’t try governance addresses directly. In the Greenwald: I think that’s a really impor- to nourish more innovations on a wide four years after Hilal got involved at CP, tant point. But you have to understand scale, then we won’t get out of the mire its value nearly quadrupled. That was that there are useful shareholder inter- that we’re in now. because he had immersed himself in the ventions and there are dysfunctional operational details of railways, under- interventions. You can imagine opening Greenwald: I think you’re absolutely stood what changes needed to be made channels for outsiders to intervene; but right. Today’s innovations are empow- and who the CEO ought to be—and the question is: are those outsiders going ering and extending the influence of it was a very effective operator named to be a distraction, or are they going to

72 Journal of Applied Corporate Finance • Volume 31 Number 3 Summer 2019 ROUNDTABLE be the Paul Hilals of the world—some- It’s not hard to do. You can take one who’s changed the operations of two over a company in Europe with basically railroads in ways that have been benefi- 30% of the voting stock. If you know cial for everybody associated with them? that industry well enough to know My sense, as a professor of invest- which executives have historically done ment management, of the investment extremely well with these very special community out there, is that they’re kind of companies; and they agree to mostly ADD troublemakers. The Paul join you, you will be successful. Hilals of the world you can count on one But it’s the supply of people with hand. Does that answer your question? special expertise like that—it’s not me, it’s the person that actually runs the Gilson: So the question then becomes, hedge fund—the Paul Hilals of the can we design an intervention system world—that are important, not the that allows somebody to readily and rules, because their value added is so credibly distinguish between the useful large. and dysfunctional interveners? I view that as a governance task that we’re not Gilson: But for our purposes, the rules doing now; but it’s not obvious to me aren’t what is getting in the way. It’s the that it can’t be done. lack of imagination—and how to make Greenwald: I think it can be done under the most of the governance system, and the present governance rules. I’m chair- the talented managers and employees, man of a hedge fund in Europe that has that we have. a very, very concentrated portfolio. We buy into one kind of company in only Greenwald: I agree. four countries, and we know exactly what we’re going to do when we take it over. Mitts: Ok, let’s leave it there.

Journal of Applied Corporate Finance • Volume 31 Number 3 Summer 2019 73 Is Managerial Myopia a Persistent Governance Problem? by David J. Denis, University of Pittsburgh*

growing chorus of commentators, ranging from politicians to prominent inves- A tors to academics, argue that U.S. corporations are myopic: that is, they are overly focused on short-term profits at the expense of long-run value. These critics often attribute such behavior to flaws in executive compensation arrangements that tie executive pay to measures of near-term performance (or value), or to pressures from short-term investors like activist hedge funds. As a result, so critics say, managers have the incentive to underinvest in projects that would produce long-term value, particularly if such investment would depress measures of near-term performance.

As I will summarize below, these critiques of U.S. corporations It would not be unfair to pose the policy issue as: Whether the are not new; similar criticisms of myopic capital allocation long-term interests of the nation’s corporate system and economy practices in U.S. companies can be found at least as far back should be jeopardized in order to benefit speculators interested … as the 1970s. To the extent such criticisms have merit, they only in a quick profit …? would imply a massive governance failure in which there has been decades of underinvestment with little adjustment on the Such concerns were echoed in an indictment of the U.S. part of managers, boards, or the market for corporate control. system of allocating capital by Harvard Business School corpo- In this article, I evaluate the economic underpinnings of rate strategist Michael Porter in 1992: these criticisms and analyze their implications in the context of empirical evidence on corporate investment policies produced [T]he U.S. system of allocating capital both within and across over several decades, the outcomes of corporate control events, companies is failing… many American companies invest too little, investor horizons, and the market pricing of companies with particularly in those intangible assets and capabilities required little if any earnings. Based on this evidence, I argue that there for competitiveness.1 is little systematic evidence to suggest that short-termism is a pervasive problem plaguing U.S. companies. If anything, In recent years, an increasingly wide variety of commenta- the body of evidence seems to point towards overinvestment tors has expressed concerns about the short-term tendencies being a larger concern. of U.S. companies. For example, several politicians have pushed for corporate reform based on the premise that corpo- Who Is Worried about Myopia? rate short-termism has been crippling the competitiveness of Concerns about myopia date back at least to the 1970s. Noted U.S. companies. Late in his term as vice president, Joe Biden attorney Martin Lipton argued back in 1979 that: warned that:

*This article is adapted from my keynote addresses at the 12th Annual Corporate Governance Conference hosted by the Raj and Kamla Gupta Governance Institute and Center for Corporate Governance at Drexel University on April 12, 2019 and the 2018 1 Michael E. Porter, “Capital Disadvantage: America’s Failing Capital Investment Australasian Banking and Finance Conference in Sydney, Australia. System,” Harvard Business Review, September 1992.

74 Journal of Applied Corporate Finance • Volume 31 Number 3 Summer 2019 Short-termism—the notion that companies forgo long-run myopic policies to persist in equilibrium. Under this view, as investment to boost near-term stock price—is one of the greatest long as corporate managers have a stake in the company’s stock threats to America’s enduring prosperity.2 price—whether in the form of direct ownership or incentive compensation—and that stock price is a function of investors’ And U.S. Senator Elizabeth Warren has argued that: expectations for all future cash flows, managers would have no incentive to pursue shortsighted or otherwise inefficient [F]rom 1990 to 2015, nonfinancial U.S. companies invested a investment policies. Moreover, because of improvements in trillion dollars less than projected, funneling earnings to sharehold- information technology that have reduced the cost of acquir- ers instead. This underinvestment handcuffs U.S. enterprise…3 ing corporate information, capital markets are, if anything, more efficient today than they were 40 years ago. Furthermore, What’s more, such arguments have not been limited to most measures of governance quality suggest that corporate politicians. Prominent investors and financiers such as Black- governance has improved over time among U.S. corporations. Rock CEO Larry Fink, JPMorgan Chase CEO Jamie Dimon, Taken together, these developments make it difficult to see and Berkshire Hathaway’s Warren Buffett have issued similar how the problem of short-termism would be worse today than critiques. Fink, for example, has written a series of open letters it was back in the 1970s. to U.S. CEOs urging “resistance to the powerful forces of Nonetheless, there are academic theories that predict short-termism afflicting corporate behavior.”4 And in a joint managers will pursue myopic policies precisely because they editorial, Dimon and Buffett stated that: have a stake in the company’s stock price. The most promi- nent of such theories was laid out by Jeremy Stein in a 1989 In our experience, quarterly earnings guidance often leads to article published in the Quarterly Journal of Economics.7 In an unhealthy focus on short-term profits at the expense of long- Stein’s model, myopic policies follow from two primary term strategy, growth and sustainability.5 conditions: (1) current earnings convey useful information about future earnings; and (2) managers aim to maximize a In support of these claims, a recent McKinsey Global weighted combination of the company’s current stock price Institute report provides evidence that companies with longer and its future stock price. The first condition guarantees that horizons outperform their shorter-term peers on a variety of stock prices will respond favorably to an unexpected increase measures of economic performance. in earnings, while the second gives managers the incentive to Finally, even some academic studies have been interpreted pursue policies that increase current earnings even if doing so as consistent with myopic managerial behavior—investment might be harmful to the future stock price. One way to boost decision-making distorted by a short-sighted focus.6 In current earnings is to cut back on investment. sum, an increasingly wide and vocal set of commentators, This theory thus predicts that systematic short-termism policy makers, and academics now believe that corporate and, therefore, underinvestment, is more likely when condi- short-termism is an issue of critical importance that must be tions (1) and (2) are more prevalent. This is likely to be the addressed either through the regulatory system or through case for companies with highly uncertain earnings streams, fundamental changes in corporate governance and capital and when managers and investors have shorter horizons (thus allocation processes. increasing the weight that managers will put on current stock price versus future stock price.) The latter condition is more Is It Possible for Myopia to Persist in a likely to be true when executive compensation contracts have Competitive Corporate Control Market? shorter vesting periods, when shareholder turnover is greater, Under the classic market efficiency view that underlies tradi- and when companies have a greater need for external equity.8 tional corporate finance theory, it would be illogical to expect Although such theories of myopia predict persistent underinvestment, it is important to recognize that these 2 See Wall Street Journal, September 26, 2016. predictions contrast sharply with the free cash flow theory 3 See Wall Street Journal, August 14, 2018. 4 Business Insider, February 2, 2016. 5 Wall Street Journal, June 6, 2018. 6 See, for example, Heitor Almeida, Vyacheslav Fos, and Mathias Kronlund, “The 7 Jeremy Stein, “Efficient Capital Markets, Inefficient Firms: A Model of Myopic Cor- Real Effects of Share Repurchases,” Journal of Financial Economics 119 (2016), 168- porate Behavior, Quarterly Journal of Economics 104 (December 1989), pp. 655-669. 185; Alex Edmans, Vivian Fang, and Katharina Lewellen, “Equity Vesting and Invest- 8 It is also likely that managers will behave myopically if investors have behavioral ment,” Review of Financial Studies (2018); and John Asker, Joan Farre-Mensa, and biases that lead them to overinflate the current period’s stock price. Both Stein’s analysis Alexander Ljungqvist, “Corporate Investment and Stock Market Listing: A Puzzle?” Re- and my discussion ignore this possibility. For a discussion of this issue, see Wei Jiang, view of Financial Studies, 2014. “Who are the Short-Termists?” Journal of Applied Corporate Finance 30:4 (2018).

Journal of Applied Corporate Finance • Volume 31 Number 3 Summer 2019 75 THE CASE OF GOODYEAR TIRE AND RUBBER

oodyear represents a clear example of the use intended to reverse the company’s diversification strategy, of a leveraged recap to increase value by limit- Goodyear initiated a recapitalization that involved a debt- G ing the company’s ability to pursue financed repurchase of more than one-third of the value-decreasing investments. In 1983, the tire company’s shares. The transaction produced shareholder manufacturer announced a diversifying acquisition of wealth gains of over 20%, amounting to over $750 million, Celeron, a natural gas producer and distributor, which while the debt service requirements forced the company to provoked a sharp negative market reaction that reduced cut back its annual investment from $1.7 billion prior to Goodyear’s value by nearly $250 million. In response to a the recap to less than $670 million after. hostile takeover threat from Sir James Goldsmith, who advanced by Michael Jensen in the 1980s.9 Under Jensen’s panied by large reductions in capital investment.10 The fact theory, managers without significant equity stakes have a that the LBOs that Kaplan studied were also accompanied by natural tendency to cause their companies to grow beyond gains to shareholders and operating improvements suggested the size that would maximize the wealth of their sharehold- that the reductions in investment had the effect of increas- ers. This tendency stems from the increase in managerial ing value—and that, before the buyouts, such companies had power that comes with growth, the fact that managerial been overinvesting, and perhaps operating with more capital compensation often increases with the size of the firm, and than they needed. the preference exhibited by corporations to reward middle In 1993, Diane Denis and I published a study of 29 managers through promotion rather than monetary compen- leveraged recapitalizations (recaps) that confirmed this inter- sation. The net result, as Jensen argued, is an organizational pretation.11 More specifically, we studied recaps in which bias toward growth that leads companies to overinvest—that public companies borrowed substantial sums and used the is, to take on low-return projects, such as diversifying acqui- proceeds to make large payouts to their shareholders. Like sitions or efforts to gain market share in mature and even Kaplan’s study of LBOs, we found that recaps of this type saturated markets. created substantial value for shareholders—on the order of So, managers of U.S. companies may be systemati- 26% in the average case—and were typically followed by cally underinvesting, as Stein’s model suggests; they may be significant reductions in investment. What’s more, in this systematically overinvesting, as Jensen argues; or since these study we were able to tie the increases in shareholder value possibilities are not mutually exclusive, both of these problems directly to the reductions in investment by showing not only could be at work in many companies. Whether companies that the recapitalizing firms invested more than their peers tend to systematically underinvest or overinvest, is, therefore, prior to the recap, but that announcements of major invest- an empirical question that can be answered only by looking ments in the pre-recap period typically met with negative at the evidence. stock price reactions. Following the recap, the investments of the recapitalized companies were constrained by the debt Early Evidence from the 1980s and 1990s taken on in the recap, and what new investments were under- If managers systematically misallocate capital, either through taken by these companies were no longer received negatively underinvestment or overinvestment, outside parties can create by the market. value by initiating transactions that reduce managerial control Both Kaplan’s study of LBOs and our study of recaps and install more efficient investment policies. The late 1980s support Jensen’s view of systematic overinvestment prior to the witnessed a boom in leveraged buyouts in which managers, onset of such highly leveraged transactions in the early 1980s. often with outside third-party investors, took companies Of course, these transactions represent only a small subset of private by borrowing substantial sums and buying out the the universe of companies, and so evidence of overinvestment shareholders. In a pioneering study of these transactions, Steve

Kaplan observed that these transactions were typically accom- 10 Steven N. Kaplan, “The Effects of Management Buyouts on Operating Perfor- mance and Value,” Journal of Financial Economics (October 1989). 11 David J. Denis and Diane K. Denis, “Managerial Discretion, Organizational Struc- 9 Michael Jensen, “Agency Costs of Free Cash Flow, Corporate Finance, and Take- ture, and Corporate Performance: A Study of Leveraged Recapitalizations,” Journal of overs,” American Economic Review 76:2 (1986), 323-329. Accounting and Economics (January 1993).

76 Journal of Applied Corporate Finance • Volume 31 Number 3 Summer 2019 in these companies does not, by itself, imply that overinvest- tant activist investors and a large number of recent studies ment was a more general problem than underinvestment in analyze the impact of hedge fund activism on corporate poli- the late 1980s and 1990s. Nonetheless, it is worth point- cies and value.13 What evidence we have, however, suggests ing out that the difficulty of identifying any studies in which that hedge fund activists typically seek reductions in invest- transactions that reduced managerial control, all of which are ment along with increases in payouts to shareholders. associated with shareholder wealth gains, led to increases in Is it possible that the hedge funds themselves are just corporate investment. responding to market incentives for short-term gains at the To cite another example, Diane Denis and I studied forced expense of long-run value? Here, again, the evidence seems to changes in top executives at U.S. companies between 1985 point to the opposite conclusion. First, as shown in Figure 1, and 1988.12 We reasoned that if managers were systematically there is evidence of both short-run and long-run performance underinvesting due to pressures for short-term performance, improvements following successful activist campaigns—that boards would have the incentive to fire the CEOs and install is, those campaigns in which the goal of reduced investment new executives who would put in place more farsighted was accomplished. Second, a recent study of innovative activ- investment policies. But what we found was that rather than ity following hedge fund activist campaigns shows that such increasing investment, the new CEOs typically decreased activism leads to a decrease in the quantity of innovative corporate investment. Following forced dismissals of CEOs, investment (as measured by R&D spending), but an increase which were typically greeted with positive stock price reactions, in innovation efficiency (as measured by patent counts and companies cut their capital expenditures by more than 30% citations) over the five years following the activist campaigns.14 relative to their industry peers while increasing their operating Taken together, these findings imply that the changes in invest- income by more than 20%. These findings further support the ment policy pursued by activists typically reduce investment, view that prior to the management change, companies were but lead to more efficient, and value-increasing, allocations investing too much, not too little. of corporate resources. The fact that we rarely observe activ- The bottom line, therefore, is that the evidence from ists encouraging companies to increase investment suggests transactions in the late 1980s and early 1990s provides little that the activists do not perceive underinvestment to be a support for the view that U.S. companies systematically systematic problem. pursued myopic investment policies that resulted in under- investment. If anything, the evidence is more consistent with Have Investors Become More Short-Term Oriented? overinvestment being the principal governance problem of Another way to assess whether short-termism has become a the time. more pervasive problem is to examine the behavior of inves- tors themselves and ask whether there is evidence that they More Recent Evidence have become more short-term oriented. On the surface, the But what about more recent evidence? As noted above, answer appears to be yes. As reported recently by Wei Jiang, concerns about myopia have become, if anything, more wide- shareholder turnover has increased from an average of around spread in recent years. I consider four types of evidence that 10% in the mid-1970s to over 350% in 2016.15 This implies speak to these concerns: (1) the demands of shareholder activ- that average holding periods have fallen from roughly ten years ists; (2) whether shareholders have become more short-term to just three or four months. oriented; (3) whether there is evidence of reduced investment; However, this evidence is misleading in the sense that and (4) whether the market appears to shun, or discount the it is driven by the large volume of trade by high-frequency value of, companies that fail to produce positive earnings. traders; and, more importantly, it masks a substantial shift towards more long-term investors. In a recent study, Paul What Do Shareholder Activists Want? Edelman, Wei Jiang, and Randall Thomas showed that the As argued above, if companies are systematically underinvest- percentage of investors with long horizons (defined as those ing, outside parties would benefit from purchasing a stake in with turnover less than 33%) has more than doubled over the the underinvesting companies, and then forcing those compa- nies to adjust their capital allocation practices towards greater 13 See, in particular, Brav, Jiang, Partnoy, and Thomas, “Hedge Fund Activism, Corporate Governance, and Firm Performance,” Journal of Finance 63 (August 2008), investment. Hedge funds represent perhaps the most impor- 1729-1775. 14 Alon Brav, Wei Jiang, and Xuan Tian, “How Does Hedge fund Activism Reshape Corporate Innovation” Journal of Financial Economics, forthcoming, (2018). 12 David J. Denis and Diane K. Denis, “Performance Improvements Following Top 15 “Who are the Short-Termists?” Journal of Applied Corporate Finance, (2018) Management Dismissals,” Journal of Finance 50:4, (December 1995). 30:4, 1-18.

Journal of Applied Corporate Finance • Volume 31 Number 3 Summer 2019 77 Figure 1 Performance improvements following successful hedge fund activism

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Industry adjusted q-ratio and return-on-assets for targets of successful investment-limiting hedge fund activist campaigns. Source: L. Bebchuk., A. Brav, and W. Jiang, “The Long- Term Effects of Hedge Fund Activism,” Columbia Law Review 115 (June 2015), Figure 3. past two decades, so that long-term investors now make up Figure 2 approximately 60% of the investor population.16 Moreover, Average investment rates for U.S. companies since 1970 this group includes the five largest U.S. funds—BlackRock, Vanguard, Fidelity, State Street, and Capital Research—whose combined assets now account for 30% of all assets under 0 management. So if anything, the evidence seems to point to a decline in short-term pressure from investors over time. 0

Is There Evidence of Reduced Investment? 0 Perhaps the most direct way to assess the claims of systematic 03 myopic investment policies is to analyze measures of invest- ea n ment themselves. Figure 2 plots average investment rates as M a percentage of total assets for publicly traded U.S. compa- 02 nies since 1970. The plot for capital expenditures highlights the evidence that is often used to support claims of system- 01 atic underinvestment due to short-termism. Since hitting a 0 peak of around 13% in the early 1980s, capital expenditures 190 193 19 199 192 19 19 1991 199 199 2000 2003 200 2009 2012 201 as a percentage of total assets have declined to the point where CA SA they now average less than 3% of total assets in most years.

While such evidence could be viewed as consistent with Evolution of average rates of capital expenditures (CAPEX), research and development short-term pressures constraining investment, the evidence is expenditures (RD), and selling, general, and administrative expenditures (SGA). All are incomplete in that it ignores other forms of corporate invest- expressed as a percentage of total assets. Source: “Persistent Negative Cash Flows, Staged Financing and the Stockpiling of ment that have been surging in recent years. In particular, Cash Balances,” David Denis and Stephen McKeon, Unpublished Working Paper, 2019. many authors and commentators have pointed out that the U.S. economy has undergone a dramatic shift from an economy dominated by investments in tangible assets such as property, plant, and equipment to investments in intangible

16 “Will Tenure Voting Give Managers Lifetime Tenure?” Texas Law Review 97 assets that take the form of knowledge and human capital, (2019), 991-1029. IT infrastructure, and brand-building. As intangibles, these

78 Journal of Applied Corporate Finance • Volume 31 Number 3 Summer 2019 Figure 3 Operating cash flow for U.S. companies, 1970s vs. 2000s

Distribution by CF/TA 20

200

rm s 10 i f

l a t o t

f

o 100

%

0

00 0 0 0 0 0 0 1 1 2 2 3 3 0 0 0 3 30 2 20 1 10 0 0 0 10 1 20 2 30 3 0 0 0 3 30 2 20 1 10 2000 190

Distribution of cash flow from operations (CF) scaled by total assets for the 1970s vs. the 2000s. forms of investment do not show up in financial statements as corporate spending averaged 33% of total assets for U.S. capital expenditures, but rather as expenses under categories publicly traded companies. By 2017, they averaged 78.7% like R&D and SG&A. of total assets. It is very difficult to conclude from this data As can also be seen in Figure 2, R&D and SG&A expen- that U.S. companies are spending less on investment in recent ditures have exploded in recent years. For example, average years. Instead, the data support the view that investment has R&D expenditures have grown from less than 1% of total dramatically increased. assets in 1970 to more than 20% of total assets in the last few And perhaps most telling, this increase in investment years. Similarly, average SG&A expenses have grown from seems to have a remarkably high correlation with—to the 25% of assets to 55% of assets over the same period. While a point where it seems to mirror—the long-term upswing in portion of SG&A undoubtedly represents normal operating stock prices. In other words, the market appears to be pricing expenses, it is not clear why this portion would have increased companies as if they have substantial growth opportunities over time. It is more likely that this remarkable growth in and companies are investing accordingly. It is also noteworthy SG&A is being driven by spending categories such as market- that the large upswing in investment is driven by precisely the ing and promotion, and human and brand capital—precisely types of intangible investments that critics argue are being the types of investment in intangible assets described above. shortchanged by short-termism.18 So, the most plausible explanation for the growth in SG&A is that it reflects companies’ increasing replacement of tangible Does the market shun less profitable firms? with intangible investments and assets.17 If companies exhibit myopic investment policies because of It is instructive, therefore, to examine the sum of capital market pressures to show short-run profits, it follows that the expenditures, R&D, and SG&A over the period depicted market systematically penalizes companies that do not show in Figure 2. In 1970, the sum of these three categories of such profits. As suggestive evidence in support of this view, the number of U.S. companies listed on public exchanges

17 To be clear, this data does not necessarily imply that individual companies are substituting intangible for tangible capital. It is likely that there has been a shift in the composition of companies making up the publicly traded universe such that a greater proportion of publicly traded companies are characterized by high rates of intangible in- 18 See, for example, Michael Porter, “Capital Disadvantage: America’s Failing Capital vestment. Investment System” Harvard Business Review, September 1992.

Journal of Applied Corporate Finance • Volume 31 Number 3 Summer 2019 79 Figure 4 Market-to-book multiples for companies with negative And perhaps even more telling is the fact that as negative operating cash flow operating cash flows have become more common, the valua- tions of such companies have continued to skyrocket. As Median Market-to-Book Ratios of Negative CF Firms shown in Figure 4, negative cash flow companies in the 1 1970s were generally viewed as troubled companies and had market-to-book ratios that were typically below 1.0. Over 1 time, however, the market multiples for these unprofitable

1 companies have risen so dramatically that by the 2010s, the median market-to-book ratios of companies with negative 12 operating cash flow had grown to approximately 1.6. In other words, companies with negative cash flow are now viewed as 10 growth companies and are accordingly characterized by high valuation multiples. Such evidence strongly contradicts the 0 notion that the market shuns unprofitable firms.

0 190 190 1990 2000 2010 Bottom Line Based on my reading of several decades of research, there is Median market-to-book multiples for companies with negative cash flow from little data in support of systematic underinvestment on the operations. part of U.S. corporations. If anything, the evidence points has declined nearly 50% since 1996.19 It is possible that toward overinvestment as the larger concern. Although corpo- younger, less profitable companies are choosing not to list on rate managers might have some incentive to boost earnings public exchanges because the short-term orientation of public at the expense of productive investment in certain situations, markets places a low value on unprofitable companies. there seems to be little systematic evidence to suggest that However, in a recent study, Stephen McKeon and I report short-termism is a pervasive problem—pervasive enough to several findings that are at odds with this view.20 First, we compromise the competitiveness of U.S. firms. find that companies reporting negative operating cash flow While traditional capital investment in tangible assets have become far more pervasive in recent years. Moreover, has declined, this decline has been dwarfed by the substantial these negative cash flows are much larger (as a percentage of growth in intangible investment. Even though these intan- total assets), and far more persistent, than they used to be. gibles are typically expensed and therefore reduce near-term For example, Figure 3 depicts the distribution of operating profits, there is no evidence that the stock market exerts profits from two periods of time: the 1970s and the 2000s. pressure on companies to avoid such investment. In fact, the From this chart, it is evident that average operating cash flows high valuation multiples of companies with high intangible have declined over time, and that a far greater proportion investment suggests the opposite. of public companies have large negative operating cash flow. In fact, in the 2000s, a striking 5% of the firm-year observa- David Denis is the Roger Ahlbrandt Sr. Chair and Professor of Finance tions have negative operating cash flow that is greater than at the University of Pittsburgh’s Joseph M. Katz College of Business. 50% of total assets.

19 See Craig Doidge, Andrew Karolyi, and Rene Stulz, “The U.S. Listing Gap” Journal of Financial Economics 123 (2017). 20 David Denis and Stephen McKeon, “Persistent Negative Cash Flows, Staged Fi- nancing, and the Stockpiling of Cash Balances, Unpublished Working Paper, 2019.

80 Journal of Applied Corporate Finance • Volume 31 Number 3 Summer 2019 The Case for Maximizing Long-Run Shareholder Value* by Diane Denis, University of Pittsburgh

uring the past 200 years, the publicly traded corporation has become the dominant D form of large-scale business not just in the U.S. and U.K., but in all developed— and some developing—economies. Perhaps the greatest advantage of the public corporation is that its defining characteristics—limited liability, tradable shares, and status as a sepa- rate legal entity—allow and indeed encourage the separation of the ownership and control of business enterprises, and the specialization of management and risk-bearing that such separation makes possible. This specialization in turn allows management teams with well- established capabilities and experience to raise the equity capital needed to build “scalable” companies, even if the managers’ personal wealth and appetite for risk are limited.

At the same time, such equity ownership gives the provid- popular films that present negative views of business and the ers of financial capital the opportunity to spread their capital profit-seeking capitalists who control them. Such portrayals across many enterprises in a variety of industries (and perhaps extend to the world of children’s entertainment, where the different parts of the world), thereby combining the financial evil corporation run by a despotic megalomaniac has long benefits of productive investment with liquidity and diversifi- been a stock feature. Consider as just one of many examples cation. And despite growing challenges from such alternative the 2014 blockbuster hit The Lego Movie, in which the antag- forms as private equity, PIPOs, S-corps, and other “pass- onist, “Lord Business,” a tyrant bent on world domination, throughs,” these benefits continue to play an important role succeeds in transforming himself into a conglomerate CEO in the durability of the public corporate form. called “President Business.” Despite their importance to the world economy—or What’s more, such characterizations, and the attitudes that perhaps because of it—corporations, especially large ones, have given rise to them, are by no means a recent phenom- frequently arouse skepticism, mistrust, and even outright enon. In an engaging history of the corporation that came hostility. Criticism of corporations abounds in scholarly out in 2003, Economist editors John Micklethwait and Adrian works, the popular press, the political arena, and the enter- Woolridge indicate that criticism of the corporate form as we tainment industry. In “Wall Street and Vine: Hollywood’s know it dates back to its establishment by the Companies Act View of Business,” an article published in Managerial and in 19th-century Britain. Decision Economics in 2012, corporate law and econom- The fundamental objections to the corporate form are ics scholar Larry Ribstein provides numerous examples of likely to be rooted in the very benefits that have led to its growth and longevity. In the minds of many, companies’ *This essay draws on and extends my article, “Corporate Governance and the Goal of the Firm: In Defense of Shareholder Wealth Maximization,” Financial Review Vol. 51, ability to grow into large institutions results in dangerous 2016, which in turn is based on my keynote address at the 2016 annual meeting of the accumulations of power, while their executives are able to Eastern Finance Association. I thank David Denis, Ken Lehn, Mark Walker, Srini Krish- namurthy, Richard Warr, seminar participants at the Eastern Finance Association annual avoid accountability for many of their misdeeds by hiding meeting, and the editor, Don Chew, for very helpful comments and suggestions. behind the “corporate veil.” Among the greatest popular

Journal of Applied Corporate Finance • Volume 31 Number 3 Summer 2019 81 grievances against corporations are the growing social and to explore the pursuit of shareholder wealth maximization as it economic inequality often attributed to high corporate returns bears on other stakeholders, with the aim of showing that these to capital and outsized executive pay, the role of corporations two systems are neither mutually exclusive nor—when properly in environmental decay, and the perceived persistence of fraud understood—even in competition with one another. and corruption among corporate executives. In making my case, I focus on two primary issues. First, In the pages that follow, I suggest that some very basic critics of the value maximization model of governance often misunderstandings about the traditional “agency-based” law fail to understand, or at least to acknowledge, that sharehold- and finance definition of corporate governance have played ers are “residual claimants”; that is, their claims to corporate a surprisingly large role in the widespread negative social cash flows and assets come at the very end of the line. This perceptions of and attitudes toward corporations. Under this has important implications for understanding the relationship traditional definition, corporate governance comprises the set between shareholder and stakeholder interests and welfare. My of mechanisms that encourage the managers of public corpo- second main argument begins by noting that the corporation rations to make decisions that maximize the long-run value of does not exist in a vacuum. The actions of corporate manag- the shareholders who are said—somewhat misleadingly—to ers are effectively governed by “external” parties whose aims “own” those corporations. There are many other “stakeholders” may have little to do with—and are often indeed in conflict in corporations: employees, customers, suppliers, communi- with—corporate value maximization. I discuss the role of two ties, and society as a whole. Many of these parties appear important external corporate governance mechanisms: media to have more meaningful stakes in the long-run success and and government. staying power of a corporation than do its typical shareholders, who are not involved in the day-to-day activities of the firm, derive only small portions of their wealth from any given firm, “ and can quickly and easily transfer their financial capital to alternative investments. To say that shareholder wealth maximization is the On the surface, then, the proposition that managers corporate goal does not suggest in any way that only should aim to maximize shareholder value appears to suggest shareholders matter. that no one matters but “the people with the money.” To the extent that the public makes this inference, it is not surprising to hear the words “soulless” and “greedy” routinely applied to ” corporations. Nevertheless, this inference represents a serious misunderstanding of what public companies must do to create Value Maximization and Corporate Stakeholders long-run value for shareholders. To say that shareholder wealth maximization is the corpo- rate goal does not suggest in any way that only shareholders Alternatives to Value Maximization matter. Shareholders’ position as residual claimants to the cash While shareholder value maximization remains the primary flows produced by the firm means that all other stakeholders governance model among academics in financial economics, with direct claims on the company—employees, suppliers, an alternative “stakeholder model” of corporate governance creditors, tax collectors—get paid before the shareholders are has evolved in management disciplines. Proponents of the entitled to any cash flow. Maximizing shareholder value is stakeholder governance model argue that the goal of the corpo- thus equivalent to maximizing the amount of cash flow that ration—and thus of its managers—is to serve the interests of remains after all other claimholders receive their due. all its stakeholders rather than the interests of shareholders A seeming flaw in this argument is that, because any funds alone. Moreover, many such models emphasize an overarch- not paid to stakeholders ahead of them in line accrue to the ing responsibility of corporations to the general social welfare. shareholders, managers acting on behalf of shareholders may Extensive debate over these seemingly competing models of have incentives to undercompensate the other stakehold- corporate governance is carried out in a wide variety of arenas, ers. However, companies must entice direct stakeholders to outside of as well as within academia. A recent Google search contract with them in relatively free product and labor markets of the phrase “shareholder stakeholder governance” resulted in which the rule of law ensures that contracts are enforced. in over 28 million hits, while “corporate social responsibility” Consider the case of employees. To the extent companies want returned 715 million. The debate is broad in scope, and the to attract people to become and remain productive employ- issues involved are many and complex. My goal in this essay is ees, companies must offer compensation and non-pecuniary

82 Journal of Applied Corporate Finance • Volume 31 Number 3 Summer 2019 benefits that exceed those of the workers’ next best alternatives, stakeholders of the company up to the level of their value to including the alternative of not working at all.1 the firm and in the broader marketplace for their services. On the other side of the equation, however, companies Therefore, for a stakeholder-based model of governance to should be willing to hire and retain only those workers whose be different from a shareholder-based model of governance, expected value to the firm is equal to or greater than the cost it must present the possibility of compensating non-share- of employing them—that is, workers whose expected marginal holder stakeholders at levels that exceed either their value products are greater than or equal to their marginal costs. A to the firm or the levels required by competing alternative model in which companies continue to employ workers whose providers. marginal cost is greater than their marginal value to the firm There are two fundamental problems with such a model is not sustainable. Ultimately, such companies will cease to of governance. First, it does not provide corporate managers exist. But as long as employees’ value to the firm is at least with a clear prescription for decision-making. For example, all as great as what they are being paid—and assuming there are other things equal, it will be in employees’ interests to receive no other employees who would do an equivalent job for less as much compensation as they can negotiate. Nevertheless, compensation—shareholder value is maximized by retaining any compensation to employees beyond what is required to those employees. retain them at the desired level of productivity reduces the This is not to say, however, that value-maximizing compa- cash flows available to shareholders—and so reduces share- nies have no incentive to offer employees anything more than holder value. And if management chooses to ignore labor the absolute minimum amount necessary to keep them at market values when setting employee compensation, how the firm. An employee’s marginal product is not necessarily should they determine how much value to take away from fixed. Because people respond to incentives, the combina- one set of stakeholders (the shareholders) and give to another tion of higher wages, better working conditions, and more (the employees)? fulfilling work has the potential to raise the marginal product The decisive advantage of market prices is that they repre- of a company’s workforce, whether because the company is sent the intersection of supply and demand by all interested able to attract employees of greater talent or because their parties. Once we leave market prices behind, what alterna- employees have more incentive to work hard. To the extent tive decision rules should managers use to determine which that the benefits of increases in productivity exceed the costs interested parties receive above-market rewards, and at the of achieving them, managers who are intent on increasing expense of which other parties? There will be at least as many shareholder value should aim to provide their employees with different opinions about this as there are interested parties. such incentives. Whose opinion will prevail? The discussion above is meant to illustrate and under- The second fundamental problem is that a system of score the fact that the corporation is best viewed as a legal corporate governance in which companies do not respond mechanism for coordinating the relationships of all its various primarily to market forces is not sustainable in an economy stakeholders. As Michael Jensen and William Meckling wrote in which companies compete with one another in markets in the most cited article in the corporate governance and for customers, factors of production, and financial capital. finance literature, “Theory of the Firm: Managerial Behav- Customers will choose to purchase goods and services from ior, Agency Costs, and Ownership Structure,” corporations the companies that offer the most advantageous combina- are “simply legal fictions which serve as a nexus for a set of tions of price, quality, convenience, and whatever else is contracting relationships among individuals.” When viewed important to potential customers. The companies able to this way, corporations begin to look less like individuals, or offer the most advantageous combinations will be those even single-purpose organizations, to which virtues or failings that employ the set of factors of production—including can be attributed. employees—that offer the most advantageous combinations of price, quality, skill, and whatever else it takes to produce Conflicts between Shareholders and Stakeholders the goods and services that potential customers demand. A model of governance with shareholder wealth maximiza- Thus, a company that overpays its employees relative to tion as its overriding goal serves the interests of other direct its competitors will not be able to compete on price, while a firm that offers lower wages than its competitors will 1 I define compensation as anything employees receive because of their job for attract lower-quality employees and be unable to compete which they can easily measure value in monetary terms: wages, benefits, etc. Non-pecu- niary benefits are things that have non-monetary value to employees: satisfactory work- on quality. Ultimately, neither company will be able to ing conditions, the ability to do fulfilling work, personal respect, etc. survive.

Journal of Applied Corporate Finance • Volume 31 Number 3 Summer 2019 83 The Market for Factors of Production although we tend to talk of shareholders and other stake- Factors of production in a free market will move to where they holders as if they are mutually exclusive groups, there is in are most highly valued. The relative bargaining power associ- fact considerable overlap between them. The ease with which ated with any factor of production is greater the more other shareholders can invest in and divest themselves of stocks opportunities there are for its use and the easier it is to redi- makes the benefits of stock market investment available to rect them to such alternative uses. anyone who has even a small amount of money they wish to While not traditionally thought of as a factor of produc- invest, provided they also have the willingness to bear the risk tion, the financial capital provided by shareholders is essential of loss that comes with equity investments. to the production of goods and services. Just as the prices of In sum, committing to value maximization as the goods, services, and the factors required to produce them, corporate goal is in no way equivalent to saying that only are set in the market, so too are the prices of shares of stock. shareholders’ interests matter. In a reasonably free-market Furthermore, there are a great many companies, private as well economy such as the U.S., all economic agents are free to offer as public, that the holders of financial capital can invest in. their resources—their time, skills, abilities, financial resources, Shareholders of publicly traded companies can quickly and etc.—to whichever companies offer them the best combina- economically remove their resources from one firm and invest tion of returns on those resources. Because other direct firm them elsewhere. For this reason alone, shareholders arguably stakeholders receive their returns before the shareholders do, have greater relative bargaining power than other stakeholders. maximizing shareholder wealth means maximizing the net A company that investors do not expect to provide a competi- present value of the entire stream of expected future cash flow tive risk-adjusted rate of return on its equity will not be able that remains. Furthermore, it is in shareholders’ interests that to raise the financial capital needed to run its business. the stakeholder claimants ahead of them actually receive their It is important to note, however, that shareholders’ greater appropriate compensation. Stakeholders who doubt whether bargaining power does not suggest that they can expect to they will receive what is owed to them will “price-protect” earn “economic rents” in the form of above-market returns. themselves up front by demanding higher compensation. In To the extent that a company’s current share price implies this sense, it is the shareholders, as the residual claimants to an expected return that is higher than the appropriate risk- corporate cash flows, who effectively bear the higher costs adjusted rate of return, excess demand by investors is expected associated with stakeholder uncertainty and risk. A model to drive the share price up until it equates to an appropriate of governance in which important stakeholders receive either expected return. below-market or above-market returns on an ongoing basis is The relative ease with which shareholders can remove their not sustainable in a competitive global economy. resources from publicly traded companies also contributes to negative attitudes toward shareholder wealth maximization. Externalities, Frictions, and Alternative Forces While such arguments take a number of forms, a basic objec- The foregoing discussion presupposes an economy in which tion stems from the idea that shareholders are “short-term” we can rely completely on market forces to protect the inter- participants in the firm, able to remove themselves at a few ests of everyone who has any stake in how corporations are moments’ notice, while the interests of most other stakehold- run. However, as economists have long pointed out, “exter- ers are longer-term in nature. Why, then, should shareholders’ nalities” associated with corporate operations and frictions interests be of primary importance? in the markets in which they operate can create situations in There are at least three points worth noting related to which there are no effective market solutions. this issue. First, by virtue of how the market prices stocks, In my discussion to this point, I have focused on direct shareholders’ interests in the companies whose equity they corporate stakeholders—those who willingly enter into hold are long-term in nature, regardless of how long they relationships with individual firms by purchasing their expect to hold the stocks. At any given moment, the value of products, working for them, selling raw materials to them, a company’s stock is the present value of all of the company’s and so forth. However, there are also indirect (or involuntary) expected future cash flows, not just those cash flows expected corporate stakeholders: parties who do not directly enter into during the shareholders’ holding periods. Second, stock prices relationships with individual companies but are nonetheless react quickly to news of changes in companies’ circumstances. affected by corporate actions. To the extent that the effects of While shareholders can depart quickly and easily when the such externalities on stakeholders are negative, they represent a company gets into trouble, the reduced price for which they situation in which stakeholders may be unable to fully protect can sell their shares will already reflect such trouble. Finally, their own interests against those of corporations.

84 Journal of Applied Corporate Finance • Volume 31 Number 3 Summer 2019 Consider, for example, a company whose operations actions, both government and media are motivated in large produce air pollution, which they could at least partially part by the desire to please broad and diverse constituencies. control by installing pollution abatement equipment. Strict Corporations are one very important constituency for both shareholder governance—with its charge to management to groups—as potential donors to political campaigns and as maximize shareholder wealth—might not support the instal- potential advertisers in media outlets. However, other constit- lation of such equipment. Its cost would be fully borne by uencies of government and media—particularly voters and the shareholders, as residual claimants to the firm’s cash flows, potential consumers—exert considerable influence as well. while the majority of the benefits would accrue to the residents For evidence of such influence, we need only look to the who live near the offending plants. spectacle of would-be 2016 and 2020 presidential candidates The existence of frictions in the market can disadvantage competing to express the greatest hostility to big business. In even stakeholders who do enter willingly into relationships addition to being influenced by their constituencies, media with individual firms. Consider, for example, the issue of and government play important roles in shaping the desires monopoly power. If a corporation prices a product such that of the general public. it earns economic rents, there is incentive for other firms to enter the market, thereby increasing the supply and lowering Media the price of that product. However, to the extent that there Especially in an information age, the media are a force to are sufficient frictions in the form of barriers to entering that reckon with. They exert influence on corporations through market—for example, high start-up costs—the corporation their ability to disseminate information and shape opinions. can continue to earn rents at the expense of its customers. Along with traditional outlets, such as newspapers, magazines, Because such rents accrue to the corporations’ shareholders and television, today’s media also include a growing online and as its residual claimants, the pursuit of monopoly power may social media presence. This allows anyone with a computer well be consistent with shareholder wealth maximization. or phone to share information or opinions with a potentially However, when viewed from a broad social perspective, the broad audience, without even leaving the sofa. In this way, surplus lost by the consumers exceeds the surplus generated the media serve to generate and transfer information across for the shareholders, resulting in a deadweight loss to the parties in the economy. economy. What are the effects of such activity? One is the poten- Nevertheless, the existence of externalities and market tial to increase market efficiency by reducing uncertainty and frictions does not imply that something other than share- information asymmetry in the market. In addition, it provides holder wealth maximization should drive managerial stakeholders, both direct and indirect, with means by which decision-making. Corporations, as I indicated earlier, do not to seek to influence corporate actions. The extent to which operate in a vacuum. Instead, their collective prominence in such efforts are successful will depend on the extent to which our lives ensures that they attract considerable attention from their messages resonate in the marketplace. Corporations must forces outside the direct corporate sphere. consider and, in some cases, confront those ideas that are Let’s now look at two of the most prominent such forces: popular enough to have potential implications for their ability media and government. My aim in doing so is to point out to attract the employees, customers, and investors they must that market forces and shareholder governance in the U.S. attract if they are to maximize firm value. are not absolutes: there are broader influences on manage- rial actions that often protect or favor stakeholders other Government than shareholders. At the same time, I will also discuss the The media’s influence on corporate actions, though powerful, implications of such deviations from strict shareholder wealth is largely indirect. It cannot force corporations to take or avoid maximization for the economy. particular actions. The government, on the other hand, has considerable direct influence on corporate actions by virtue Constraints on Market Forces of its ability to regulate. Consider, for example, the corpo- Critics of corporations point to their considerable power. rate pollution of air and water I identified earlier as a prime However, government and the media are also powerful forces example of a market externality. The U.S. federal govern- in the U.S. economy. A large body of empirical and anec- ment, under the auspices of the Environmental Protection dotal evidence suggests that these two institutions together Agency, exercises considerable control over corporate emis- exert considerable influence on the actions of corporations. sions. The fact that it takes 465 pages to enumerate all of the In terms of their incentive and ability to influence corporate requirements of the Clean Air Act, and another 234 pages

Journal of Applied Corporate Finance • Volume 31 Number 3 Summer 2019 85 for the Clean Water Act, strengthens the EPA’s regulatory is best, the election-based need for money and votes from a hold over even the most compliant corporations. Thus, while wide variety of constituencies, and their desires for personal strict shareholder wealth maximization may not lead manu- power and financial gain. facturing corporations to protect the interests of those indirect The idea that there are situations in which the greater stakeholders who live near their plants, the government is social good warrants departures from strict shareholder an overriding force in ostensibly providing such protection. wealth maximization is quite reasonable. The problems arise, Similarly, the U.S. government exercises considerable control however, when trying to define the precise circumstances over corporations’ ability to amass market power by impos- under which this is true. Government influence over corporate ing antitrust laws. actions replaces the consensus decisions of a broad market- The media, too, play a role in mitigating the negative place of stakeholders employing their own resources to act in effects of market frictions and externalities generated by corpo- their own interests with decisions made by a much smaller rations. The potential effects of widespread information (and group of government officials with complicated incentives and deliberate misinformation) about negative corporate actions control over resources generated by others. Such replacement on corporate reputations can interfere with such companies’ is warranted only when effective market solutions do not exist. ability to attract customers, high-quality employees, and other Furthermore, there must be clear and compelling reasons in direct stakeholders. such cases to think that the government is able to make better In addition to governments’ ability to impose regula- decisions than the market about any particular issue. If the tions, its ability to tax its constituents—companies as well as government is, in fact, overly responsive to those with great individuals—provides the government with further tools with wealth and power, that can hardly inspire confidence in their which to influence corporate actions. Consider, for example, decision-making. the wide variety of tax deductions and credits available to What are appropriate roles for government with respect to businesses that engage in green energy initiatives, whether corporations? This is a loaded question, and I will not attempt in terms of their own energy usage or of the production of to provide an exhaustive list of even just my own thoughts on green products for sale to consumers. Add to such business the matter. However, I will propose two categories of such incentives the tax credits available to consumers who purchase roles, while urging that we exercise care even within these green products—electric cars, solar energy systems, and many categories. others—and we have a system in which the government has First, I believe there is an important role for government to a considerable impact on both the demand for and supply of play in the protection of stakeholders from the negative effects green products. of corporate externalities and market frictions. Unchecked Critics may well argue that the ability of the government pollution has potential adverse consequences for many in to protect those stakeholders whose interests the corporate society who are not in a position to contract on the matter pursuit of shareholder wealth maximization does not suffi- with the offending corporations. However, we must carefully ciently protect is limited by the fact that corporations—in weigh the social benefits of regulating against any externality particular large corporations—have an undue amount of or friction against the social costs. Zero pollution, for example, influence over government. There is merit to this argument, is not a realistic goal. At some point, further reductions will to the extent that such influence results in outcomes, such as require that some products that many consumers value either higher corporate profits or prices to consumers, that deviate cannot be produced at all, or not at a price consumers can from what we would observe in a competitive market. Many afford to pay. The great challenge for policy makers and regula- corporations are significant donors to political campaigns tors is identifying the point at which the social costs of regulation or employ lobbyists to exert influence on government. In outweigh the benefits. Meeting this challenge requires that addition, the government may be reluctant to risk corporate the government truly has at heart the interests of society as a outcomes that would adversely affect significant numbers of whole, as opposed to those of favored interest groups. corporate stakeholders. In such situations, the government Second, I believe there is an important role for the may go so far as to bail out corporations rather than let them government to play in identifying and remediating corporate fail. wrongdoing. If market forces are to protect the interests of We should not view this, however, as an indictment of the direct corporate stakeholders, they must be able to contract corporate form. Such outcomes are better viewed as reflecting with corporations with the expectation that both sides will act the interplay among the varied and often conflicting motives in good faith and as they agreed to do. Similarly, if governments of government agents: their individual opinions about what are to protect stakeholders from externalities and frictions for

86 Journal of Applied Corporate Finance • Volume 31 Number 3 Summer 2019 which market solutions are insufficient, appropriate rules must indeed repeatedly throughout U.S. history—this combina- be set and followed. This requires that governments hold all tion gives rise to a classic moral hazard problem in which corporations, and their relevant individual decision-makers, to banks maximize their own expected value by taking on risk the terms of their contracts and the rules that are set, regardless that the market would be unwilling to finance at the given of the degree of their political influence. Corporate fraud and expected return without government backing. This added risk corruption not only harm individual stakeholders, they also is effectively financed by the taxpayers—a group that includes contribute to negative social views about corporations. The the same investors who would be unwilling to finance these challenge, of course, lies in defining what constitutes corporate additional risks if they were given any choice. wrongdoing. Rule-makers must balance the intended benefits The intended consequence of government bailouts of large of potential rules against their costs, including those arising institutions is to avoid the temporary chaos in the market that from unintended consequences. would result from such a failure. The increase in corporate risk It would be difficult to overstate the importance of beyond what is financially justified in the market is a serious restricting government involvement in the affairs of corpora- unintended consequence. To the extent that the government is tions to the arguably limited situations in which the benefits concerned about this increase in risk, it may interfere further of such involvement outweigh the drawbacks. And there are in the workings of corporations—say, by dictating how much many drawbacks. First, as noted above, government involve- cash or equity companies must maintain, or how much or in ment effectively replaces the will of the many in the market what form they must pay their employees. The government, with the will of the few in government. Second, govern- however, lacks the specific knowledge needed to determine ment regulations are by nature one-size-fits-all solutions to appropriate policies and risk levels for individual corpora- complex problems. Government regulations that are ill-suited tions. Invariably the one-size-fits-all mandates they impose to individual corporations can limit their ability to follow will lead some firms to avoid taking on taking on appropriate the most beneficial course of action. Furthermore, regulatory risks, thereby depriving the economy of valuable growth and prescriptions can reduce a corporation’s incentive to carry out development. Government involvement in corporations is a the analysis needed to determine its own appropriate course of very slippery slope. action. As one example of what can go wrong when businesses rely too heavily on regulation, the Titanic carried on board Shareholder Wealth Maximization and Social Welfare the government-regulated number of lifeboats; but because Recent years have witnessed an explosion of interest in how it was considerably larger than any ship before it, this was corporations do—and should—affect social welfare. Terms only half the number of lifeboats needed. Finally, government like ESG (environmental, social, governance), CSR (corporate involvement invariably has consequences beyond the govern- social responsibility), and sustainability are commonplace in ment’s presumed intentions—unintended consequences with corporate boardrooms, corporate marketing, investor relations the potential to harm individual economic agents. Perhaps communications, and the popular press. Underlying each of worse, they may lead to further ill-advised regulation designed these concepts is the idea that corporations have a responsibil- to blunt their impact. ity to pursue environmental and social concerns, in addition As an example, consider the issue of corporate risk-taking. to financial concerns. This is the so-called triple bottom line, Risk is inherent in business operations. Corporate investment sometimes referred to as planet, people, and profit. I will refer in appropriately risky projects benefits the economy as a whole to them collectively as ESG. by providing employment, goods, and services. A publicly Proponents of ESG vary in their prescriptions for corpo- traded corporation operating in a free market maximizes its rate behavior and the resulting implications for shareholder long-run value by taking on appropriate risks and avoiding wealth maximization. At one end of the spectrum, proponents the risks for which the expected return is not high enough to make the case that attention to social welfare can and should justify them. be used to maximize company value—that well-designed, Suppose, however, that government policies essentially cost-conscious environmental and social policies have finan- break the link between risk and return. Take the case of banks, cial payoffs in the form of more loyal employees, suppliers, deposit insurance, and too-big-to-fail policies. Depositors, and customers. Under this view of ESG, there is no conflict when protected by deposit insurance, provide banks with between shareholder and stakeholder governance mechanisms. funds at below-market cost. In addition, big banks expect A growing body of research evidence provides promising—if that government will step in with public capital if they get into somewhat mixed—evidence that companies that score highly enough trouble. As became clear during the last crisis—and on measures of ESG perform better financially, on average.

Journal of Applied Corporate Finance • Volume 31 Number 3 Summer 2019 87 At the other end of the ESG spectrum is the view that when they do not coincide in individual economic agents. corporations have a moral obligation to use their considerable When we allow such combinations to operate in relatively power and resources for the social good, even at the expense free markets, we get business enterprises that provide members of shareholder value. For example, corporations that commit of society with the goods and services they need or desire, to “the highest standards of verified social and environmental the ability to earn their livelihoods, and the opportunity to performance, public transparency, and legal accountability earn financial returns that provide them with better futures. to balance profit and purpose” can become Certified B (for Because such benefits are considerable, it is difficult to imagine “benefit”) Corporations. This certification is granted—in that the basic corporate form is in danger of disappearing. return for an annual fee—by the U.S. nonprofit B Lab. As Traditional ideas about the appropriate goal of the corpo- of March 2018, 35 states and Washington D.C. had passed ration, however, are increasingly in danger. In 1970, Milton legislation that allows a company to incorporate as a benefit Friedman proposed in The New York Times Magazine that the corporation, as an alternative to a traditional C corporation. social responsibility of business is to increase its profits. The Finding solutions to such vexing problems as inequal- traditional definition of corporate governance, with its goal ity and poverty are admirable goals. And to the extent that of shareholder wealth maximization, effectively reflects Fried- some investors are willing to sacrifice financial return for such man’s views. The publication of his views set off a firestorm of pursuits, some B Corporations may be able to privately raise debate that continues to the present, and criticism of share- the capital they need to do business. However, it is likely that holder wealth maximization comes from many corners of the set of such investors—and therefore the number of B society. Corporations they can finance—will remain small. Corpora- As I see it, the main source of such criticism is a misun- tions that compete in public capital markets must commit to derstanding of value maximization: how it is accomplished, maximizing long-term value to attract the capital they need to what it entails, and what its implications are for other stake- do business. For those companies that undertake ESG invest- holders. Reducing value maximization to the proposition that ments without the expectation of a payoff for investors, the “only the shareholders matter” gives the misleading impression likely outcome is unwanted attention from shareholder activ- that the good of the corporation and the good of the rest of ists, or even private equity investors, who can create value society are in conflict. In truth, however, companies maximize simply by “undoing” such investments. And if such external shareholder wealth by providing other direct stakeholders with forces fail to materialize, corporations that persist in overin- market-determined returns on their contributions to firm vesting in ESG are likely to end up jeopardizing their existence value. When the returns to all stakeholders, including share- as independent companies and, along with it, the continuing holders, are set in a free market, economic outcomes reflect stream of social benefits realized by all their stakeholders in the collective decisions of economic agents acting in their the normal course of corporate activity. own interests using their own resources. Thus, under normal circumstances, and in the vast majority of cases, what is good Finding the Balance in the Governance of for a corporation is also good for society. Until this proposi- Corporations tion is well understood, corporations are likely doomed to be Where then does all of this leave us? Is the modern corpo- underloved and over-regulated. rate form of organization in jeopardy? Are corporations as a Public discontent with large corporations is an important class doomed to be social pariahs: underloved and over-regu- impetus for excess government involvement in corporations. lated? Or can we find an appropriate balance—one in which For this reason, widespread misconceptions about corporate corporations are allowed and can be trusted to maximize the motives, goals, and ways of achieving them are dangerous for economic well-being of society? Finally, what role can finan- society’s economic well-being. Individual corporate stakehold- cial economists play in addressing these issues? While it is ers, be they consumers, employees, or shareholders, generally beyond the scope of this essay to do justice to these questions, have both the ability and the incentive to make decisions that I provide a few thoughts in closing. are in their own interests. Corporations who seek to maximize The modern corporate form of organization has survived, shareholder wealth follow a clear decision rule that most often prospered, and expanded around the world during its more results in market-based returns to all of their stakeholders. than 150-year history because it provides for and encourages Governments, by contrast, typically have neither detailed the efficient use of society’s economic resources. Thanks to knowledge of the interests of individuals or corporations, clear limited liability and the tradability of shares, managerial/entre- decision rules for determining whose interests to maximize, preneurial talent and financial capital can come together even nor their own resources at risk. How, then, can the government

88 Journal of Applied Corporate Finance • Volume 31 Number 3 Summer 2019 be expected to make superior decisions? The government’s role in which the good of corporations and the good of society are in the workings of the corporation should be to step in when legitimately in conflict. And, finally, on a more personal level, market solutions truly do not exist and to enforce the terms of as our children and grandchildren are exposed to movies and the nexus of contracts that constitute the modern corporation. stories about evil corporations, we can make sure they hear What can financial economists do to improve the reputa- the other side of the story. tion of the corporation in society? First, we can work to educate the population about the implications of shareholder Diane Denis is the Terrence Laughlin Chair in Finance at the wealth maximization and about the important role that corpo- University of Pittsburgh’s Katz School of Business. Her research rations play in social well-being. Second, we can be part of focuses on corporate governance and other corporate finance issues. the dialogue on how to identify and address those situations

Bibliography Friedman, M. (1970). The Social Responsibility of Micklethwait, J. and A. Wooldridge (2003). The Company: Business is to Increase its Profits. The New York Times A Short History of a Revolutionary Idea. New York: Random Magazine, September 13. House. Print. Jensen, M.C. and W.H. Meckling (1976). Theory of the Ribstein, L.E. (2012), Wall Street and Vine: Hollywood’s Firm: Managerial Behavior, Agency Costs and Ownership View of Business. Managerial and Decision Economics 33: Structure. Journal of Financial Economics 3: 305-360. 211-248.

Journal of Applied Corporate Finance • Volume 31 Number 3 Summer 2019 89 A Tribute to Joel Stern by Bennett Stewart, Co-Founder and Former Senior Partner, Stern Stewart & Company

oel Stern was Managing Partner of Stern Stewart & Company and its successor, J Stern Value Management. He was previously President of Chase Financial Policy, a global consulting arm of the Chase Manhattan Bank, where he founded a predecessor of this journal called the Chase Financial Quarterly. He died on May 21, 2019.

Joel Stern was brilliant and driven—and the funniest and most Joel led the way, as no one else could, and always in a manner charming person I have ever met. His combination of finan- designed to be provocative. He saw finance as a Manichaean cial knowledge and penetrating insights, peppered with some struggle between the light of the “economic model” of value of the most outrageous—and outrageously funny—anecdotes, and the darkness of an “accounting model” of value. Finance was irresistible. can be esoteric and dull—but then came Joel. He was a teacher and a translator. He could simplify and illuminate abstruse concepts in finance and economics First Principles and make them fun, lively, and accessible. He had a limitless “I claim that the mom and pop running the corner grocery store passion for thinking through corporate finance issues— know more about corporate value than most business executives,” parsing them, debating them, refining them—and tried to he asserted. “Why? Because they do not have a P&L and balance instill that same passion and commitment in his clients, sheet to confuse them. They have a cigar box. The cash goes in, colleagues, and students. the cash goes out, and as long as the lid on the cigar box is rising, He was a staunch free marketeer—an intellectual disciple the value of the business is going up.” of Milton Friedman, Merton Miller, and Gary Becker, who He reduced this thought to an aphorism: “Earnings per were his professors when he attended business school at the share don’t count, it’s Free Cash Flow that really matters.” University of Chicago. He loved his business school alma He had a tie clip engraved with those words, a gift from the mater and always referred to it affectionately as the mother CEO of Union Carbide. Joel wore that clip every day. And if church. someone questioned his model, Joel would walk up to that Perhaps most significant, Joel developed the foundations person, ask him or her to read the tie clip out loud, and then of Economic Value Added, or EVA, and inspired generations announce, rather severely, “Do you think I would have that of business practitioners to measure and reward performance on my tie clip if it wasn’t true?” in ways that create value for shareholders. He literally invented He conducted two-day management forums on corporate the terms NOPAT and Free Cash Flow, which of course are finance for hundreds of companies all over the world. In his still widely used today (although not always as he defined opening remarks, he would declare, “Would you believe that them). all the reputable research in finance demonstrates conclusively I first met Joel in 1976 when I joined a consulting group that accounting measures of value, such as earnings, earnings- he had formed at the Chase Manhattan Bank. Known as per-share, earnings growth, and profit margins, simply do not Chase Financial Policy, the group’s goal was to translate the matter?” One prominent CEO’s response: “Joel, I am very best academic research and insights into business practice. It happy to hear it, because we are not having a very good year.” was—and is—a noble purpose, and was especially needed at Joel would single out a company’s controller—and the the time. Major new finance theories were percolating out of accounting profession in general—for special opprobrium. the business schools, led by a constellation of future Nobel It all began, he declared, when he took a required course in laureates and the advent of computers and databases that accounting at Chicago. On the first day of class, the professor enabled researchers to test the theories and sort truth from went around the room to each student and asked, “What is the myth. There were many sacred cows to be slaughtered, and best way to measure a company’s performance?” The answer

90 Journal of Applied Corporate Finance • Volume 31 Number 3 Summer 2019 in every case was some variant of earnings, net income, or fewer low-PE B shares outstanding in the form of the higher- EPS—until he got to Joel. Joel’s answer: “It definitely cannot PE A shares, and so EPS will go up—regardless of the identity be earnings! I read ahead to the chapter on inventory costing. of the two companies, regardless of the potential for synergies, If a company takes coal out from the top of the coal bin, that regardless of whether the merger makes any sense at all. The is Last-In, First Out, or LIFO, and from the bottom, that is increase in EPS is simply arithmetic. First-In, First Out, or FIFO. Although the coal is all the same, To put the nail in the coffin, Joel asked what would in a time of rising prices, LIFO costs are higher than FIFO happen if we turned the deal around, and B acquired A to costs, which will reduce reported earnings, but by paying form company BA. The math reverses. Company B must issue lower taxes on lower earnings, the company has more cash in a larger number of its lower-PE shares to retire the higher-PE the bank. Which would you rather have—the greater book shares of company A, but once again the earnings are additive, profits of FIFO, or the greater cash flow of LIFO?” leaving company B with lower EPS in the wake of the deal. “Joel,” the professor responded testily, “in this class, I am Joel would ask, rhetorically, “How can it be good for A to the one asking the questions. And for our purposes, the answer buy B but bad for B to buy A, when AB and BA are the same is earnings. So I ask you again: how do we measure corporate company?” His insight was that because AB and BA will have performance?” the same combined earnings and the same combined value, Joel, without hesitation, responded, “Earnings!” When they will have the same PE multiple, somewhere between A’s asked why he had changed his mind so suddenly, Joel said that and B’s original multiples of 10 and 20. As a matter of pure in the economics department they teach that there is a price arithmetic, the buyers’ PE ratios will have to converge just as for everything, and he wanted to get out of the accounting surely as their earnings-per-share will diverge. course alive. “This is how markets work,” Joel asserted. “Earnings-per- share really doesn’t count. But management won’t see it that All Growth Is Not Equal way if their compensation is tied to EPS. They will let the Joel developed a simple example to show why EPS growth is accounting tail wag the business dog.” a poor measure of company value. Two companies, X and Y, Joel’s prime nemesis was dividends. “I cannot under- have the same earnings growth. They are the same in every stand why any company, anywhere, anytime, has ever paid way, except that company X has to invest a lot more capital a dividend! Companies are valued for what they do, not each year to produce the same earnings growth as Y. Which for what they don’t do. Paying a dividend is an admission company is more valuable? of failure—management’s failure!—to find attractive ways Joel’s answer: Y, because it generates more Free Cash to reinvest the money,” he would rail. “Your investors want Flow—more economic earnings net of investment. It also dividends? They can invest in bonds as well as non-dividend- earns a higher ROI—a higher ratio of earnings to the capital paying stocks or sell shares and pay a capital gains tax only on employed in the business. Joel darkly suggested that if success the gain.” It was a tour de force in applying withering logic to were measured by earnings growth, managers could simply slay another sacred cow. He would reiterate, “Earnings don’t spend their way to success by pouring capital into uneconomic count, growth doesn’t count, dividends don’t count!” Joel’s projects. tongue-in-cheek conclusion: “Nothing matters!” In the 1960s and 1970s, conglomerate acquisitions were all the rage. In many cases, companies manufactured EPS The Proof Is in the Pudding growth by acquiring companies selling for lower PE multiples, Once, during one of Joel’s management presentations, an which automatically gave EPS a boost. Joel maintained that attendee had the temerity to ask how part of a formula was this made no sense and dubbed it the “AB-BA fallacy.” derived. In those days—pre-computer and PowerPoint—Joel Company A trades for 20 times earnings, and company made his presentations on a 25” by 30” easel pad and an B for 10. Company A issues its higher-PE shares to acquire assortment of oversized markers. Every time he made a presen- all of B’s lower-PE shares to form a company called AB. The tation, he had to totally recreate each page, but he was very question is, what always happens to company AB’s earnings- well rehearsed at this. per-share relative to company A’s? Joel would point out that His response to the client: “I am sorry, I no longer do “always” is rare in corporate finance, but in this case, if you derivations, and let me tell you why. When I was younger, got the wrong answer, you were definitely wrong. I thought I had to prove that my formulas were right. I was The answer was that company A’s EPSalways go up. The asked to give a presentation to the management committee of earnings of companies A and B are additive, but there will be the Chase Bank. Sitting in the front row was the senior execu-

Journal of Applied Corporate Finance • Volume 31 Number 3 Summer 2019 91 tive poohbah of some department of the bank. This fellow had last reveal how to calculate c, without which the model was a reputation for sleeping in meetings, so they put him right useless. in the front row. ARE YOU READY FOR THIS, he would thunder at the “I began my talk,” continued Joel, “and soon enough, I top of his voice. AT THE CHASE MANHATTAN BANK, dove into my derivations. At the third easel page flip, I notice WE DO NOT KNOW HOW TO CALCULATE C. I the senior executive’s head starting to roll and his eyelids WANT TO THANK YOU VERY MUCH FOR COMING. growing heavy. I spoke faster and wrote more dramatically to THIS IS THE END OF THE FORUM. GOODBYE. But grab his attention, but his head only spun more wildly out of then a minute later—and to everyone’s relief—he would control and then his eyes closed. The next thing I knew, he show a roundabout route he had developed to calculate c. fell completely out of his chair and his head landed right on The model is dead, long live the model. Joel had saved it. top of my shoe!” One company was so enthralled with the prospect of the As Joel told it, he turned and asked, “What do I do now?” finale that the CEO arranged to pipe in “Stars and Stripes And the answer, from none other than David Rockefeller, was, Forever” just as Joel began the maxi crescendo. It was magnifi- “Joel, speak softly.” cent. And he and his management team liked the presentation This story never failed to get a laugh, and completely so much that they hired us to help them with the valuation settled any need for a derivation. of an acquisition. We frequently would get business this way He had done all the derivations, of course. And to his because the clients were impressed by the clarity that Joel immense credit, he was eventually able to translate the famous provided about how to create shareholder value—and frankly, Miller-Modigliani (“MM”) valuation model into a much the entertainment value was also a factor. more accessible format—and without the need for formal Joel loved the Chase Bank, which was as prestigious an proofs. He’d become a Ninja, a true black belt, riding on a institution as you could imagine in those days, and he used higher plane of proficiency. I sometimes think he understood this to his advantage. He often told stories about people and the models better than the inventors of the models did. companies, not always flattering, and to assuage a client’s In their classic 1958 paper, “The Cost of Capital, Corpo- concerns that he might do the same to them, he would find ration Finance and the Theory of Investments,” MM wrote the an opportunity to say, “If I mention a company during our first term of their valuation formula—the value of a company’s two days together, I want you to know that we have obtained base business—as X over ρ. Literally, Greek. their permission—or, at the Chase Manhattan Bank, we do Joel renamed X as NOPAT, or net operating profits after not like their management!” taxes—the earnings from the firm’s existing asset base. He On the rare occasion that a jest fell flat, he would say, figured out how to estimate NOPAT from accounting data, “During our time together, I will be relating seven pieces something we had never learned in business school. NOPAT of worthless information, and if you are counting, that was is in wide use today, and it’s Joel’s invention. He also renamed number four.” The way he would say this—the timing, the ρ as “c,” representing the cost of capital, or cutoff rate, which look, the audience reaction—it always worked. They say that is the required rate of return to compensate for business risk. people learn best when they are entertained, in a good mood, It is the rate used to capitalize the current NOPAT earnings laughing. It opens and relaxes the mind. Joel was living proof. to measure the value of the base business. He was the master. To build suspense, Joel purposely saved the computation of c, the cost of capital, until the conclusion of his two-day Debt and Taxes management forum. This segment was held to be so impor- The second term in the MM valuation formula, as Joel tant that Joel described it as “the maxi crescendo,” and played explained it, is tD, or the corporate tax rate multiplied by the it up throughout the two days. From his initial failure as a company’s debt. There’s a tax benefit to using debt because wonky presenter, Joel had gone on to master the thespian the interest is tax deductible. There are formulas to show this. skills. At times he would wind up to a roar, for a commanding But Joel would tell a story instead. emphasis, and at others his voice would melt into the softest One day, so the story went, Joel and his father were sentences. It was mesmerizing. walking companionably in the family apple orchard (which So with half an hour left on the second day, Joel would we’ve yet to definitively locate), each lost in his own thoughts. at last announce that the Chase Manhattan Bank marching Suddenly Joel’s father broke the silence. band was assembling outside to accompany this final and “Son, I don’t know how to tell you this, but…we don’t most important part of the forum, in which he would at pay any taxes.”

92 Journal of Applied Corporate Finance • Volume 31 Number 3 Summer 2019 The audience would immediately perk up because this is The show held an annual contest for the best stock picker. not the typical father-son bonding talk that they were expect- At the beginning of the season, each panelist got to pick one ing. stock, and whoever picked the best-performing stock for the “How so?” asks Joel, in great Socratic tradition. year was the winner. Most panelists would spend weeks doing “Well, the apple farm earns a modest profit, but it’s offset research to make their pick. Joel would simply ask us to pick a by the interest on the money we’ve borrowed. We owe no tax.” stock for him with a very high beta, because if the market went “But then how then do we live,” Joel asks, “if we have no up, as it more likely would than wouldn’t, the highest-beta profit?” stock would go up the most. Joel won several times, certainly “Simple, Son. We borrow against the increasing value of more than his share. The best part was watching him justify the land and pay it out as a dividend. We harvest the value his stock on television. tax free.” If this seems disingenuous, it wasn’t. It was entirely consis- They walk on a little further, and then it occurs to Joel to tent with the so-called efficient market theory, developed at ask, “But Father, who is going to pay off all the debt?” the University of Chicago while Joel was a student, which Brief pause. states that all public information is already factored into stock “Son, I’m sorry to have to tell you this, but…you will!” prices. You can throw darts to pick stocks because you are Drum roll and cymbal, please. protected by research already conducted by smart-money Self-deprecating humor was a big part of why Joel was so investors, which ensures that companies are trading at their successful. He liked to recall the time he asked a question of a fair values. Back in those days, this idea was hugely controver- man sitting way in the back of a large theater, who responded, sial. Today, it reigns supreme, with indexes and ETFs replacing “Sorry, I cannot hear you and I cannot see you,” at which active managers. But how to explain this, way back then? point, so Joel says, a man sitting right up-front calls out, “Well Joel did it by explaining why the price of apples is the I can hear him and see him fine, would you like to trade same in two stores that sit across the street from each other. places?” “One possibility,” he said, “is that all shoppers visit both There was a period when Joel was into tennis and took stores to check the prices. But that’s not really necessary. If lessons with a top pro in Cape Town, South Africa, which was just a few shoppers visit both stores, they will exert sufficient a country he loved to visit. When Joel got the bill for his first pressure to bring prices in line.” At this point, you’re nodding lesson, it was a whopper. Joel protested, “We only played an in agreement—but you’ve just been set up. hour, but you charged me for two.” “That’s right, Joel. It’s one “Even that is not really necessary,” Joel declaimed with hour for the lesson and one hour to get my game back.” And stentorian flair. “All that’sreally required is for the store manag- remember, it’s Joel telling this story. ers to visit each other’s store and check the prices—for fear that shoppers will.” Stock-Picking and Lead Steers Joel would continue: “Prices in the stock market, as in all People frequently asked Joel for stock tips, and occasionally markets, are set at the margin by the smartest, most informed, he would oblige, but usually he would brush it off by saying most motivated money in the game. Stock prices are not set “You don’t want a tip from me. My portfolio is currently under by a polling technique in which all investors have a vote on intense scrutiny at the MIT Sloan School of Management— value. There is a small group of savvy institutional investors—I for its tendency to lead the market down and to barely hold call them the dominant, price-setting investors—that set the its own during major market rallies.” market.” In the 1970s, Joel was a rotating panelist on the television This led to perhaps Joel’s most inspired metaphor. Merrill show Wall Street Week, hosted by Louis Rukeyser. It was an Lynch at the time was running ads featuring its bull mascot incredibly popular show featuring talk on the stock market; it on the run. Merrill brokers were referred to as the “thunder- was Bloomberg and Fox Business News way before their time. ing herd.” Merrill was bullish on America. It was an extremely Joel claimed that his nickname among the panelists was Pluto, well-known brand and marketing campaign. Joel cleverly because he rotated the least frequently. appropriated it. He started to call the dominant price-setting At one point, the show conducted a survey to explore the investors “the lead steers.” appeal of each panelist, and found that Joel’s largest fan base Joel loved to tell the story of the lead steers. “If you want was women over the age of 80. Joel said he cringed whenever to know where a herd of cattle is going, you don’t have to he heard an emergency vehicle’s siren, for fear he was losing interview every steer in the herd. Only the lead steers. It’s the one of his flock. same with stocks.” And people readily understood this.

Journal of Applied Corporate Finance • Volume 31 Number 3 Summer 2019 93 One day, however, Joel was on a flight from Dallas to To illustrate, he created a simple example, which nearly New York, when (according to Joel) an honest-to-goodness ran off the width of his flip chart. Starting with $1,000, cowboy—spurs and all—sat in the seat beside him. So Joel assume a company can compound returns at a 25% rate of started a conversation and the man confirmed that, yes, he return, while investors can compound value at only a 10% was a big Texas rancher, and he was on his way to New York return by purchasing a stock and bond portfolio of the same to meet his investment banker. Joel figured that this was risk. The difference, which reflects distinctive company assets the perfect opportunity to talk about lead steers, so he said, and proprietary capabilities, is the firm’s EVA profits: “Let me tell you how stock prices are set. You don’t have to interview every steer in the herd, just the lead steer.” Company earns 25%: $1,000 $1,250 $1,563 $1,953 The cowboy chuckled, and said that it was a great concept. Market portfolio earns 10%: $1,000 $1,100 $1,210 $1,331 “There’s only one problem, Joel,” he said. “The steers don’t lead the herds; the cows do.” Economic Value Added: $150 $353 $622 Joel said later, “All I could think was that Merrill Lynch was in big trouble.” This simple example was the springboard that eventu- I was listening to Bloomberg radio recently when I was ally led to a new financial management system and cottage reminded of Joel. The question over the airwaves was, “Isn’t industry that put Stern Stewart on the map and on the cover there a lot of cash on the sidelines that could come into the of Fortune magazine. EVA was, as Fortune said, “today’s hottest market and drive it higher?” On the surface the question financial idea and getting hotter” and “the real key to creating sounds reasonable. But Joel was fond of pointing out that for wealth.” EVA was vigorously discussed and tested at business every buyer there must be a seller, and for every seller, a buyer. schools and adopted by legions of companies globally. At The only way a lot of cash can enter the stock market is if an its peak, the Stern Stewart consulting organization that Joel equal and offsetting corps of investors are rushing to leave and I founded in 1982 as a spinout from the Chase Bank it. The cash that comes in is matched by the cash that goes employed hundreds of professionals in 16 offices globally. The out. Nothing has happened, on net. Trading volume simply EVA revolution has become a permanent feature on the corpo- indicates that value is uncertain, not that it’s going higher. rate governance landscape—helping companies to structure It’s a simple, brilliant insight, and relevant even to this day. compensation and allocate capital in ways that create value. This is all Joel’s legacy. None of it would have happened The EVA Legacy had it not been for Joel Stern blazing the trail. There will It’s time to circle back to the third and final term in Joel’s always be reasons to remember his insights, to recall his version of the MM valuation formula. (I’m tempted to call humor, and to wish that he were still with us. for a marching band.) The third term is the value of profit- able growth opportunities. The idea is that a company with a competitive advantage can earn more than an investor who Bennett Stewart is Senior Advisor at Institutional Shareholder owns a comparably risky stock and bond portfolio. The differ- Services (ISS). In 1982, he and Joel Stern formed the financial consult- ence each year is what Joel called “Economic Value Added,” or ing firm of Stern Stewart & Company. In 2006, he became CEO of EVA EVA. It’s the value that the company can generate that inves- Dimensions LLC, which was recently acquired by ISS—thus ensuring tors can’t replicate. And the present value of that extra EVA that EVA will remain a definitive measure of financial quality worldwide. profit is the last term in the MM valuation model.

94 Journal of Applied Corporate Finance • Volume 31 Number 3 Summer 2019 A Look Back at the Beginnings of EVA and Value-Based Management

An Interview with Joel M. Stern, Chairman and CEO of Stern Value Management, January 16, 2014

Joe Willett: Let’s start at the beginning—The Chase Manhat- I said, “About six months, and $10,000.” “What about our tan Bank circa 1968. You had an idea, and you were successful balances?,” he asked. I was sorely tempted to stick to my guns in getting people to buy into that idea. The idea was that on the fee, but I said, “I have to admit something to you, sir. modern finance had something to say to CEOs and CFOs, I’m here on a priority because of the balances that you keep as well as to bankers to some degree. Tell us a little about how with us. Otherwise I wouldn’t be here.” He signed me up on you got started. the spot. And that was our first project.

Joel Stern: I wanted Chase to differentiate itself by having Why Dividends Don’t Matter a reputation for expertise in modern corporate finance. I Willett: You were well known for saying that dividends don’t wanted the commercial lending people to be able to talk seri- matter, as a counterpoint to the widespread belief that raising ously about topics that were helpful to the client, and to spot the dividend was a surefire way to make the stock price go up. opportunities where Chase could provide advice. That idea What was your reasoning? resonated with members of Chase’s senior management, and they gave me an opportunity to develop a financial consult- Stern: Until the late 1950s, the predominant view was that ing function. As we started meeting with different companies, if a company didn’t pay cash dividends, its share price would some of the bankers were astounded at the level of interest on never amount to anything. Even today, you’ll come across the the part of their clients. They shouldn’t have been surprised, occasional money manager who says that the companies creat- though, because modern finance is fundamentally about what ing the most value are the ones raising dividends and doing determines the value of an enterprise, which is a topic of criti- share buybacks. But that view is completely contrary to what is cal interest to CEOs and CFOs. taught at the premier business schools today—Chicago, MIT, the Simon Business School at Rochester, or UCLA. After all, Willett: At what point did you realize there was a business here? dividends gained are equal to capital gains lost. They have to Were you at Chase, or was it before you got to the bank? What be because there are no free lunches in this world. was the “aha” moment? Of course, it’s entirely possible that the share price will go down when a company initiates or increases its dividend if Stern: It was in the training program at Chase, where I met investors infer that the company no longer has as many value- people who were being assigned to other locations around the creating investment opportunities. That’s what happened to bank. At the time, Chase was organized geographically. I had Intel in the early 1990s. Alternatively, a company’s share price met the fellow who was eventually put in charge of Ohio and could go up when it disgorges surplus cash in the form of a Pennsylvania, and he invited me to go with him to see the trea- dividend—because investors no longer have to worry about surer of Bethlehem Steel about doing a free cash flow valuation that cash being squandered on value-destroying projects; in project. I should also mention that he stipulated that I do other words, so-called agency costs have been reduced. the project for nothing—even though my little group, Chase As an aside, I have to say that agency theory has never Financial Policy, was a profit center—if the treasurer reminded entirely resonated with me. I have the highest regard for us about the balances that the company kept at Chase. Keep Michael Jensen, who was a classmate of mine at the Univer- in mind that there was no interest paid on demand depos- sity of Chicago, but he never developed a theory to account its at that time, so these balances were very profitable for the for why management would tend to misbehave in the first bank. At the end of my presentation, the treasurer said, “That’s place. There are two reasons why management should behave one hell of a presentation. We should definitely be looking itself: the first is the threat of an unfriendly takeover, and at free cash flows as opposed to what we are currently doing. the second is that boards of directors should design incen- How long would your work take, and what would it cost?” tive contracts that lead management to maximize value in

Journal of Applied Corporate Finance • Volume 31 Number 3 Summer 2019 95 their own self-interest. In addition, research by Raghuram What’s more, tying bonuses to accounting profits encourages Rajan, Henri Servaes, and Luigi Zingales shows that there accounting manipulation by the senior management, because are dynamics inside the firm at the middle-management if they see a business slowdown there is a temptation to cut level that encourage value maximization. Middle managers back on very important investments in intangibles in order to aspire to senior leadership roles, so if the senior management smooth out the earnings. The other aspect of this, of course, attempts to engage in self-dealing or other value-destructive is the idea that “what gets measured, gets managed.” At firms behavior, there is internal pressure from middle managers to that are spending billions of dollars a year on R&D, who is cease and desist. The same argument applies with the threat going to remember what was spent yesterday, last year, or the of unfriendly takeovers—middle managers don’t want the year before? The answer is nobody. But it is in the sharehold- firm to be taken over because they aspire to senior manage- ers’ interest to make sure that management is held accountable ment positions of their own, so they exert pressure on senior by putting those items back on some sort of economic balance management to behave itself. sheet that boards of directors look at. My second basic criticism of the accounting frame- Willett: At the same time, there are incentives to misbehave, work is its failure to include a cost of equity capital. That is too, because much of this bad behavior simply isn’t detected. a very big problem because many companies are criticized for being “profiteers”—but if you include a cost of equity Stern: I don’t disagree, but there’s a cap on it, and here’s why. capital, reported profits drop tremendously to reflect the use Think about the premium you have to pay to gain control of a of investor capital. Ideally, the income statement would report firm in an unfriendly takeover. Let’s assume that the premium a number that reflects the shareholder value created, or what is 25%. If you multiply that premium by the cost of capi- we call EVA for “economic value added” or MVA for “market tal, which we’ll assume is 10%, you get 2.5%. So 2.5% of value added”—although I would prefer “management value the value of the firm is vulnerable to managerial bad behav- added” because management has been entrusted with a certain ior. More than 2.5%, though, exposes the management to an amount of capital and they should be held accountable for unfriendly takeover. creating value above that amount of capital. Of course, boards can’t necessarily be counted on to hold senior management accountable. For example, the pooling EVA and Incentive Pay method of accounting for business combinations, which was Willett: The idea that management should be evaluated on the eventually eliminated by the Financial Accounting Standards basis of its actual contribution to value is fundamental to the Board, obscured the economic returns earned on an acqui- EVA system, correct? sition—so if incentive compensation were based on the accounting framework, it would not reward or penalize senior Stern: Yes. The late Fischer Black maintained that much of managers appropriately. However, proponents of an economic what management does is due to simple luck, and he’s not model of value would say that what matters is how much wrong in the sense that a company’s performance is a func- was paid for the acquisition, rather than how it is reported tion of the state of the economy in general, the state of affairs afterward. in the company’s industry, and the discretionary performance of management. If you could filter out the economy, which Why Earnings Per Share Don’t Count accounts for about 50% of a company’s share price perfor- Willett: What in particular do you see as the failures of the mance, and the industry, which is another 25%, you would accounting framework? have a measure of what management has accomplished. By the way, that’s why I question the use of restricted stock and Stern: In general, I have two basic criticisms. The first is that stock options to motivate people—75% of the share price it expenses intangibles in the current year. The main intangi- change has nothing to do with management. bles are research and development, long-term brand value, and But the first time I presented the concept of rewarding employee training and development. For some companies, management on the basis of what they had actually accom- training their employees is their biggest capital expenditure. plished, the CEO started laughing—because he was imagining When I was at Chase, almost everybody below the level of a shareholder meeting in which his company had had an awful middle management went to some type of training program year, but he was asking for substantial bonuses for his manage- every week. How do we hold managers accountable for the ment team because Joel Stern had analyzed the company’s results of this training if it is expensed in the current year? performance and found that in the face of a terrible economy

96 Journal of Applied Corporate Finance • Volume 31 Number 3 Summer 2019 and challenging industry conditions, management’s perfor- started to turn around. This technique is important in highly mance had been quite good. He told me point-blank that no cyclical industries, where performance goes down sharply and public company could get away with paying bonuses in a bad then rebounds sharply. year on the basis of a model that filters out general economic The main point, as I said, is to filter out the economy and and industry factors. the industry and reward management’s discretionary perfor- That’s when we devised what we eventually called the mance. And I define a five-year period of sustained results “bonus bank,” although at the time I called it a “deferred incen- as a reasonable approximation of discretionary performance. tive compensation account,” or DICA, because I wasn’t smart Virtually every company that has done it this way has had enough to come up with a catchphrase like bonus bank—that’s really tremendous outcomes. In fact, the most successful firm why I employ talented people. I telephoned that CEO and on EVA is Godrej in India, which implemented EVA with us in explained the bonus bank to him, and he hired us immediately. about 2001. Adi Godrej explained to me that his most impor- tant asset was the human capital in the firm, and he wanted Willett: At the time, did you define the bonus bank so that it to get their compensation right. Since implementing EVA, his could go both up and down? stock price has gone up at a compound annual rate of better than 40%. Today, it is 68 times higher than it was in 2001. Stern: Yes. Which means that it’s not a bad idea to implement the bonus bank in a bad year, when managers would ordinarily What Creates Value? not be getting bonuses. If you implement in a bad year, then Willett: How did you first get started down this path? you have only upside. But we are not actually paying bonuses in a bad year—the bonus is paid out over a five-year period. Stern: I was very interested in the basic issue of the drivers of That’s an important difference between the bonus bank and shareholder value. The most important paper for anybody who a guaranteed deferred bonus. A deferred bonus is like restricted cares about value is the dividend policy paper by Franco Modi- stock—there is retention risk, because if you leave the company gliani and Merton Miller, published in 1961 in the Journal you lose your bonus, but the actual amount awarded is not at of Business, called “Dividend Policy, Growth, and the Valu- risk. With the bonus bank, the employee is paid out over a five- ation of Shares.” In Section I, they talk about basic issues of year period, as long as the payments are based on sustainability value—dividends and capital gains, which sum to TSR or total of the improvement in EVA. Thus the deferred amount is at shareholder return—and they cover a lot of ground but it’s a risk. By the way, the bonus bank is not for people below middle somewhat convoluted discussion. Section II, though, which management because they don’t have policy responsibility. is called “What Does the Market Really Capitalize?,” is the But it’s also important not to implement at the beginning whole ballgame. They compare four things: dividends, earn- of a bad year. We did this in the early 1990s for a company ings, cash flow, and investment opportunities. And they show in Atlanta called Printpack, and as soon as they went onto that all four are really the same. our program their results headed straight down because of When I teach this to my class, I start with return on invest- the recession. At the end of the first year, everybody had a ment, where investment in the denominator is the sum of debt negative bonus bank. I pointed out to the CEO, Dennis Love, plus shareholder funds at book value. The numerator is net that there is no more cyclical an industry than packaging, and operating profit because if the denominator is total capital, that with the end of the recession the company was about to then the numerator has to be attributable to both lenders and have a gigantic leap back up, and all of the negative bonuses shareholders—that is, before any payments to lenders. Next, would be erased. But I realized that we might need to make we add back depreciation to get the gross cash flows. But if a modification for highly cyclical companies, and that was depreciation is equal to capitalized maintenance, then we are when I came up with the idea of paying bonuses on the basis right back to net operating profit, which is just the free cash of improvements in performance in order to smooth out flow. The full credit for the concept of free cash flow definitely bonuses in highly cyclical industries. Normally, the bonus goes to Merton Miller. declarations would first have to offset any negative balance in In a world with no corporate income taxes and no superior- the bonus bank, which might mean no payments for several returning projects, it doesn’t pay to invest more money. Of years depending on the size of the initial drop. So we suggested course, if you do have superior-returning projects, then it all paying one-third of any improvement in performance, with changes, and you’ll have to raise capital to finance growth. And the remaining two-thirds applied to the negative balance in that leads to another interesting question: Why is it that compa- the bonus bank. That way everyone got bonuses when things nies will not issue new shares to finance organic de novo growth,

Journal of Applied Corporate Finance • Volume 31 Number 3 Summer 2019 97 but they are willing to issue shares to acquire another company? Stern: Even if you go to a fine business school like the Simon The answer is that they’re “EPS crazy.” They don’t want to dilute Business School or any of the others that I mentioned earlier, EPS—and if you are undertaking organic growth and financing the professors who teach corporate finance and valuation it with equity, the EPS might not catch up for awhile because will tell you that debt is cheaper than equity because inter- of start-up and other costs. It’s very surprising to me how many est expense is tax deductible. I once attended a luncheon companies still design incentives around EPS and end up forgo- at which Eugene Fama was the guest speaker, and he said ing profitable growth because it will hurt EPS in the short run. during his talk that he was not allowed to teach corpo- Our basic rule from modern finance is that if you have a rate finance at the University of Chicago because he didn’t publicly traded company, you should run it as if it were privately believe that there was any value created on the right-hand owned and make the decisions you would make to maximize side of the balance sheet—not from dividends, not from value as a private entrepreneur. If you explain to the markets buybacks, and certainly not from borrowing money. I agree what you are doing and why, then the market will fully appreci- with Fama. Why? As Merton Miller pointed out in “Debt ate what you are doing, and you will not see any loss of value in and Taxes,” his 1976 presidential address to the American your share price. That’s what Warren Buffett is really all about. Finance Association, if the interest tax deduction is legiti- Warren Buffett came to visit David Rockefeller at Chase back mate and debt is really cheaper than equity, then the optimal in the 1970s, and I was in the meeting, and he said, “Listen, we debt ratio has got to be a lot higher than anything compa- don’t pay dividends, and we are never going to pay a dividend as nies are currently doing, which is typically more like 30% long as I live.” I remember Mr. Rockefeller’s surprise— “What? debt and 70% equity. Why not?”—and Buffett responded, “We can earn a much Most people make the mistake of thinking that companies higher rate of return than our investors can on the outside.” should load up on lots of debt in order to take full advantage I was working with a company in South Africa that of the tax-deductibility of interest. But the amount of the tax was earning 32% after tax on capital employed, let’s call shield is limited by the company’s return on investment. You it Company A, and because Company A was 40% owned want interest expense to equal earnings before interest and by Company B, it paid a generous cash dividend to satisfy taxes (EBIT), which shelters all of the EBIT for tax purposes Company B, which relied on those dividends to boost EPS. and thus maximizes value under the traditional view. Of It was Company B’s belief that the market value of its shares course, that gives you an EPS of zero, but the market will was related to EPS, rather than to the value of Company know that you’re creating value by taking advantage of the A—which was also a publicly traded company, so everybody tax shield. could see both companies’ value on the stock market at the At the time, others tried to explain “suboptimal” debt same time. I suggested that Company A give its shareholders ratios by citing bankruptcy risk if the firm is overleveraged, a choice between cash dividends or a stock dividend, which but Jerold Warner, a finance professor at the Simon Business is the equivalent of reinvesting back into the firm at no cost. School, showed in his PhD thesis that bankruptcy costs aren’t In the U.S., where stockholders have the choice of receiving nearly large enough to warrant that type of worry. a cash dividend or a stock dividend, the stock dividend is In his “Debt and Taxes” speech, Miller came up with a taxed as an ordinary cash dividend, but in South Africa the formula for the tax shield of debt that involved the corporate tax law is different. The CEO of Company A maintained income tax rate and individual income tax rates on bonds that his shareholders would all want the cash dividend—but and shares for personal investors. He showed that because in fact 96% of his shareholders went for the stock dividend. the corporate income tax rate is roughly equal to the personal At that point, the CEO of Company B expressed concern tax rate on bonds, the tax shield on debt is a function of the that his proportional ownership in Company A would start personal tax rate on shares, which is a pretty small number to fall if he took the cash dividend. As I explained to him, because the capital gains tax rate is low—and can be deferred that was the price he was paying for not maximizing value. indefinitely—and the tax rate on cash dividends is signifi- So he announced to the market that Company B would also cantly lower than the regular income tax rate. So Miller be taking the stock dividend, and his shares rose. It was one concluded that debt is not cheaper than equity. I was there of those moments of complete vindication. for the talk, and I was sitting next to a finance professor from the University of North Carolina who looked at me and said, The Question of Optimal Capital Structure “I am too old for another revolution in finance.” Willett: Let’s talk about another subject related to value—the Frankly, when I teach my class, I present it much more impact on shareholder value of debt versus equity financing. simply. If we assume that there are only three players in

98 Journal of Applied Corporate Finance • Volume 31 Number 3 Summer 2019 the world—borrowers, lenders, and the government—and time, there has to be a reason. Jensen and Meckling argued borrowers get a tax deduction for the debt, who pays for it? that debt serves to monitor and discipline the management, The government could pay for it by simply printing money, which reduces the costs of managerial self-dealing. but that won’t accomplish anything. What happens is that the Another argument was made by Stephen Ross of MIT. lenders have to pay the tax, so they gross up the interest charge He says that the reason shareholders ask for dividends, and shift the tax burden back to the borrower. especially in capital-intensive companies, is not that they want the money back but that they want the company to Willett: Wasn’t that Miller’s argument? have to raise additional capital to fund the dividend payment, because in the course of raising capital the company will hire Stern: It is Miller’s argument, though he did not present it an investment bank that will have its reputation on the line that way. and will therefore investigate the company and its projects Another company that I worked with in South Africa before underwriting any sort of offering. In other words, the needed to raise about $100 million. The CEO asked me to investment bank will certify the quality of both the company’s go with him to the bank to ask for a loan. We met with the management and its projects. chairman of the bank, who said something astonishing—he Those are the two arguments. Jensen took agency theory said that my client could either borrow the money from the a step further in his 1989 article called “Eclipse of the Public bank, or issue preferred stock to the bank, and the rate would Corporation,” which is still one of Harvard Business Review’s be the same. I actually telephoned Merton Miller from South largest-selling reprints. In that article, he says that publicly Africa—the call nearly bankrupted me—and he wasn’t in the traded companies with few profitable growth opportunities— least surprised, although he said that the banker was making a and hence little need for more equity capital—are going to small mistake in that the rate on the preferred should be a tiny disappear into KKR-type companies so as to bring ownership bit higher than the rate on the loan because the preferred stock and management closer together. would be junior in the event of insolvency. But, essentially, debt isn’t cheaper than equity. Willett: To beat the agency problem? Preferred stock has an advantage over equity in that it is always fairly priced—it sells on a yield-to-maturity basis like Stern: Right, to beat the agency problem. Jensen’s view of a debt instrument, and it will always command fair value. the world is that to prevent managers from squandering the With common equity, you may be diluting your true value by corporate surplus, we’ll build mountains of debt and use the giving the shares away at too low a price if there are informa- cash surplus to pay down the debt, and when the debt gets tion asymmetries, as can happen when management possesses down to a certain level, we’ll take on more debt, and when information that is not yet available to the market. Preferred we pay that down, we will do it again. Essentially, we are stock is a perfect substitute for common stock for financing taking the present value of the stream of future dividends and growth opportunities. paying a large part of it upfront. But in my view, that argu- ment doesn’t make sense because it is playing defense. We are Willett: Did the company in South Africa have any other debt? trying to stop the management from doing bad things. What if, instead, we gave management an uncapped EVA bonus Stern: It had some debt on the balance sheet already, yes. system? If they think the sky’s the limit, they will reach for the sky. Not only that, the incentive structure should go right Willett: So the claim in bankruptcy will be relevant. If you down to the shop floor, so that every employee will behave were able to issue preferred stock, and had a covenant that like a value maximizer. said you couldn’t issue debt, then it’s no different from debt. By a stroke of luck, we were hired by Briggs & Strat- ton right around that time, and the big hero in this story is Stern: That’s correct. And the fact that debt is not cheaper John Shiely, who was the company’s general counsel at the than equity rules out that motive for borrowing money. But time—he was the one who wanted to carry EVA right down there’s a little more to the story. In 1976, Michael Jensen and to the bottom of the organization. No one had ever thought William Meckling wrote their paper on agency theory, and it that way before. Fred Stratton agreed and communicated to had a very big impact. Jensen is a positive economist, which his employees that they were now part of an EVA company. means he believes that markets get what markets want. If That’s the secret—if the CEO sets the value-maximization almost all companies have borrowed money for almost all of focus and says, “This is important to me personally”—if the

Journal of Applied Corporate Finance • Volume 31 Number 3 Summer 2019 99 CEO is an EVA champion—then there will be no game- in the cafeteria having lunch and overheard somebody say playing. The employees will go for it. John Shiely eventually that the company was going to hire an additional admin- became the CEO and is still a very dear friend of mine. When istrative assistant. She thought about it all afternoon and we talk about this, he says that what we did was to explain in then wrote a note to the CEO telling him not to hire the simple terms how to focus on value, and that everyone at the additional admin. I asked her why she had done this, and company always felt that they were maximizing the present here was her answer: “I want to be on the team.” In other value of the company’s future because the EVA incentives had words, she wanted everybody to know that she could be been carried right down through the entire organization. His a value-change agent, too. I told the CEO the story over was the first company to do it. lunch, and he observed that the big problem in management is what people do when the CEO is not watching. Are they More on Incentive Compensation imaginative? Are they creative? Do they try to think about Willett: Why do you want the employee on the shop floor, ways to improve performance? Or are they talking about or the salesperson dealing with the customer, thinking about yesterday’s soccer match? So the second reason that I want EVA and not focusing on making the product or selling the EVA implemented throughout the organization is that EVA product? puts everyone on the same team, and everyone on the team becomes a value-change agent. Stern: Excellent question. You are right—I don’t want people Think about an airline. Next time you’re flying somewhere, being rewarded for company-wide EVA, I want them being go over to where the flight attendants are standing and try to rewarded for the part of EVA that they can influence. There are overhear their conversation when they’re not working. They’re two reasons. The first is that the thing we are really up against not talking about ways to improve the performance of the is negotiation. The first thing a human being learns is to cry, so airline at all. Wouldn’t it be nice if they were? We could make that mommy and daddy will pick the baby up—and from that a list of ten things that a flight attendant does and have the point forward the baby is in charge of the family. That’s called passengers evaluate them as satisfactory, unsatisfactory, or negotiation. People feel that their negotiating skills are strong outstanding, and those assessments could be the EVA driver enough that they can earn more through negotiation than by for the flight attendants. Then you would really notice some having to produce in order to generate the same compensation. differences. Put simply, EVA removes the negotiation factor. Whole Foods is on EVA. If you walk into Whole Foods As an aside, that’s the problem with the Balanced Score- and ask an employee where the salad bar is, he or she will walk card. Number 1, it’s not balanced, and number 2, there’s you to the salad bar and make sure to point out all the specials no score. Why has it become popular? So management can along the way. At other supermarket chains, the employee will divert attention away from the failure to create financial say, “Salad bar? Aisle 8.” What makes Whole Foods so success- value in the organization; so they can say, “Listen, there are ful is that their employees are value-change agents. 15 variables here in the Balanced Scorecard, we got 9 right, The first company in South Africa to implement EVA was and 6 not so much. Tell me, what’s my score?” It becomes South African Breweries. At the time, the company also owned a negotiation. a hotel chain and an underperforming grocery chain. The To explain the second reason that I want people rewarded CEO asked me to look at everything, and I recommended that for their contribution to EVA, I have to tell you a story about he divest the hotel and grocery businesses and implement EVA a retailer in South Africa. About four years ago, I went to in the core brewing business. That company is now SABMiller, the company headquarters to have lunch with the CEO, and one of the two largest beer companies in the world. the receptionist in the lobby said to me, “I know who you I had a similar experience at Coca-Cola. The first thing are—I am on your EVA system. You did the training for us we convinced them to do was to get rid of Taylor Wines and in our intranet training program.” I was ecstatic! I asked her Columbia Pictures. Coca-Cola is still on the EVA program, what impact it had had on her, and then she shocked me: although they did go off it for a few years. They went back “No impact whatsoever.” I was taken aback, but I asked her on because they did an econometric study that showed that to explain. She said that she had initially found the concepts EVA had the highest correlation of any measure of company interesting but hard to follow, and the numerical examples performance to changes in the premium of market value to were hopelessly confusing—but she asked a coworker to help book value. her, and eventually she caught on, although she still didn’t EVA is very straightforward—one of its best features is really see how it affectedher . Then one day she was sitting that it doesn’t cause employees to maximize the wrong things.

100 Journal of Applied Corporate Finance • Volume 31 Number 3 Summer 2019 When I was at Chase Bank, lending officers were compensated Willett: Are there any companies for which you can’t design a in part on the basis of loan volume. If you reward people for good EVA program? loan volume, you’ll get loan volume. With an EVA system, loan repayments would also be part of the bonus calculation Stern: When we first started out, I didn’t see how it could because loan repayments are part of the value calculus. work for extractive industries such as oil and gas, mining, Again, it’s not EVA bonuses, it’s EVA drivers. We did or forest products. So for a long time we didn’t implement some work for a large Chicago-based company some years EVA at any of those companies. But then one of my part- ago, and I discovered that the accounts payable were being ners pointed out that the value of the reserves is recorded in paid in 26 days. A company that size, with their suppliers— a footnote, so we could actually make the appropriate adjust- what were they thinking? After doing a little investigating, ments in order to make EVA work for extractive industries. I went to the CEO to tell him why his people were paying early. He asked, “Is this going to be unpleasant?” “Very,” I Willett: What about a company like Amazon? said. His people were being taken to Chicago Bulls games by their suppliers, who were getting favorable trade terms in Stern: That’s a great example. Insurance companies are in the return. I suggested that he have his people take the suppliers same situation. When insurance agents sell policies, they get to the games and let them know that the new trade terms two types of commission. The first is for landing the policy, were 46 days. which is a big commission. Then they get a commission each In 1996, I made a presentation to the Board of Governors year, but it is much smaller. So the problem for a life insurance of the U.S. Postal Service. LeGree Daniels, who was the first company in the early stages of its development is that all it African American to be appointed to Pennsylvania’s Depart- has are losses, because it’s paying huge commissions. But does ment of Revenue, was on the board at the time and heard it make sense to try to slow things down in order to generate my presentation. She came up to me afterward and said, “I accounting profits? That’s the advice that Amazon has gotten. will sign on for EVA on one condition only. You drill it right Remember our discussion of intangible assets? Amazon has down to the shop floor. This is not meant for senior manage- three: start-up costs on the distribution centers, training and ment. This is meant for everybody.” Then she went to Marvin developing of its people, and marketing costs. All three are Runyon, who was the U.S. Postmaster General at the time, being expensed in the current year. If you took those expenses and told him the same thing. At the time, the Post Office was and put them on the balance sheet, and recalculated ROI, you losing $2.4 billion a year. They implemented EVA, and within would see that it is quite positive. two years the losses had been eliminated. At the time, of course, I was subscribing to a number A lot of companies have incentive compensation plans of academic journals, and I began to realize that academics that are based on the consolidated results of the company. were doing two things that were not good for CEOs and They’re called profit-sharing plans. But if you’re fairly low CFOs of companies. They were focusing on very narrow issues in the organization, you have no impact on the consoli- without putting them in the context of the big picture, and dated results. That only encourages what is called a free-rider they presented everything in terms of mathematics, statistics, problem. You want to have the individual business units, and econometrics. It struck me that their research would be or what I call EVA Responsibility Centers, rewarded on much more valuable if it were written in simple English and the basis of what they can actually contribute. In order to if it provided a broader statement as to where the particular make sure that it works firmwide, based on Ronald Coase’s issue fit in with the overall scheme of things. It was in my research, about 50% of your rewards should be based on how early years at Chase that I wrote what became known as the your local unit is doing, and the other 50% should be based “Blue Book”—it had a blue cover made from a vegetable dye on how other units are doing. That way, if you come up that came off on your fingers, so you could tell if someone with good ideas for other units, you will share them because had actually been reading it. That book took some of the you still have 50% riding on how they do. Such an arrange- foundational research in finance and showed how it led to the ment also provides internal diversification—so that when a free cash flow model. My contribution was recognizing that unit is doing poorly, it will be supported by other units that academics had worthwhile things to say to CEOs and CFOs are doing well. EVA programs recognize that employees are of companies, but they had to speak in a language that would bearing the total risk of the enterprise instead of just the not be foreign to those CEOs and CFOs. We subsequently non-diversifiable market risk. went on to start a journal, which is now the Journal of Applied Corporate Finance.

Journal of Applied Corporate Finance • Volume 31 Number 3 Summer 2019 101 Summing Up Stern: Yes, that’s true. But an EVA system wouldn’t reward Willett: As I think about the developments in modern finance, brokers simply on the basis of churn. it strikes me that they mainly occurred between 1958 and 1978. What’s happened since then? Willett: Are there any negatives on EVA?

Stern: Good point. Fischer Black left academia for Goldman Stern: The big negative on EVA is that CEOs have to be will- Sachs, and became a partner there. When I asked him why, ing to give up some of their decision rights. In other words, he said, “We’ve already done everything,” he said. “Nothing if you are going to hold the people downstairs accountable, major will happen in academia for at least a generation.” That then you have to be willing to give them enough rope to was his observation. hang themselves. But there’s another, more subtle nega- But here’s what I would say. I’ve begun to realize that tive. CEOs have to be willing to give up their “patronage” human capital management is a big part of what is called role. What do I mean by that? I made an EVA presenta- corporate finance. In other words, if you want to maximize tion to a media CEO, and at the end, he said, “Fabulous, the value of the firm, you mustn’t look only at your physical but I’m not going to do it.” Why? Because he liked being capital decisions. No firm should want to have employees—they able to go around to people at the end of the year and shake should want to have partners in the creation of value. When their hands and tell them how much he had decided to give Brian Kantor was at the University of Cape Town, he was them as a bonus. As he put it, “Under your EVA program, I involved in some research that showed that changes in EVA are don’t do anything at the end of the year except thank them about 70% affected by management decision processes, whereas for working in the organization.” That’s an overstatement, the stock price is only about 25% affected, as we have already of course—because even in a company on an EVA system, talked about. So since EVA is more closely tied to what manage- managers still have to manage and CEOs still have to lead ment can actually do over the business cycle, I began to realize and provide vision. But the benevolence factor is removed that having all employees focusing on the contribution they because bonuses are awarded objectively and for sustainable can make to that process is really a fundamental requirement performance. of maximizing the value of an organization. Willett: Joel, thanks very much for sharing your thoughts. Willett: Has your thinking on dividends changed at all? What’s next for you?

Stern: My position is essentially the same. Why are dividends Stern: We are forming a new company called Stern Learning paid? Well, some people are afraid that management will squan- Systems, and I’m going to create a series of lectures on EVA der those funds otherwise. But in my world, management that we will make available on the Internet. doesn’t squander. The reason they don’t is because of pressure from the people downstairs—the argument of Rajan, Servaes, Willett: That’s a great vehicle for you. and Zingales that we discussed earlier. I agree with the view that there is tremendous pressure inside the firm—but I want that pressure to be even greater, and it will be greater if we have Joel M. Stern is chairman and CEO of Stern Value Management, chair- clearly defined incentives tied to sustainable improvements in man and CEO of Stern Solutions Capital Partners, and chairman of Stern EVA for each EVA Responsibility Center. My view is that by Learning Systems. He serves on the faculty of eight business schools, far the most motivated person in any firm, below the level of including Columbia Business School, the Tepper School of Business at top management, is a salesperson paid on a commission basis. I Carnegie Mellon, the University of Chicago Booth School of Business, the want to pay people a commission for creating value as opposed University of Cape Town, and Universidad Francisco Marroquín (UFM). to simply generating sales, and I believe that we can define how sustainable value is created at all levels of an organization. Joseph T. Willett worked at Merrill Lynch & Co., Inc. for 20 years, including six years as its chief financial officer and four years as chief oper- Willett: Commissions can be a problem, though. The broker- ating officer of the Europe, Middle East, and Africa region. Before joining age industry is a good example where it doesn’t work. It Merrill Lynch, he worked for six years in the Financial Policy Division at pits the interests of the broker against the interests of the The Chase Manhattan Bank, headed by Joel Stern. customers.

102 Journal of Applied Corporate Finance • Volume 31 Number 3 Summer 2019 EVA, not EBITDA: A New Financial Paradigm for Private Equity Firms by Bennett Stewart, Senior Advisor, ISS

s EBITDA—cash operating profit—the best way to measure value and monitor a I business? Should company managers be asked to increase EBITDA and be paid bonuses for doing that?

Private equity (PE) firms, as a rule, think the answer is “Yes,” ing Enterprise Value within 43 industry groups was 38% for and not without cause. Many of them have been very success- EBITDA, it was 57% for EVA. ful using EBITDA (earnings before interest, tax, depreciation, As these findings suggest, private equity firms that begin to and amortization) as a formula to measure and grow value. use EVA will be able to value companies more accurately and EBITDA is also a critical measure of the cash flow available with greater insight into the factors determining their value. to service debt, and the ability to service debt is usually a PE They will also be able to use EVA as a better tool to monitor priority. their portfolio companies and keep tabs on their performance Nevertheless, EBITDA is less correlated to market value and plans. Some PE firms may even decide to bring EVA than is commonly thought, and it is riddled with omissions in-house for some of their portfolio companies and use it to and distortions that make it a highly unreliable guide to how improve their decision-making. As the PE business continues well a company is performing. We argue that there is a much to mature and become more competitive, smart firms will look better metric for valuation and management purposes—so for every advantage they can find. For some, EVA could make much better that PE firms should consider adopting it to the difference between success and mediocrity. replace EBITDA or, at the very least, to complement it. In this article, we explore the shortcomings of EBITDA A Simple Example of Why EBITDA Is a by comparing it to EVA (Economic Value Added), which Poor Measure of Value measures a firm’s true economic profit after deducting a full, Let’s begin with a simple example that shows why EBITDA weighted-average cost-of-capital interest charge on the net may provide a misleading measure of value. assets used in the business. Imagine two companies, call them A and B, that have the EVA is effectively the exact opposite of EBITDA in the same EBITDA and projected EBITDA growth rate. If the two following sense: It is measured after taxes, after setting aside companies also have the same risk profile, then one would be depreciation and amortization as a proxy for the cash needed forced to conclude that their value is the same and that they to replenish wasting assets, and after ensuring that all inves- would trade for the same multiple of EBITDA because they tors—lenders as well as shareholders—are rewarded with are indistinguishable. competitive returns on their capital. EVA is the bottom-line But now suppose that company B needs to invest less profit score that directly discounts to value. capital into its business each year to produce the same Our empirical review suggests that stock values are deter- EBITDA as company A. Can we now say for certain that one mined by the EVA profits that companies generate, and that of them is more valuable? EBITDA multiples are plug figures—that is, a byproduct of In fact, we can. Company B is unquestionably worth more valuation, not a cause of it. In our analysis of the Russell 3000, than A. Its investors are entitled to the same EBITDA year by for example, we find that whereas EBITDA explains only year while keeping more money in their pockets. Company 9% of variations in Enterprise Value, EVA explains 22%. In B’s “free cash flow”—that is, its cash flow from operations net a second test in which we examined the values of companies of investment spending—is higher, which leaves it with more within distinct sectors, we found, here again, that EVA has cash to distribute to investors. Put more simply and directly, greater explanatory power. Where the median R2 in explain- company B gives investors a higher rate of return on the capital

Journal of Applied Corporate Finance • Volume 31 Number 3 Summer 2019 103 they’ve committed to the company. The ratio of EBITDA EBITDA is distorted by bookkeeping rules that do output per unit of capital input translates into a higher yield. not always reflect economic reality—rules, for instance, And more to the point, company B earns more EVA. There’s that require the expensing of R&D outlays, or deducting more economic profit that remains after deducting a lower cost- reported pension costs. of-capital capital charge on a smaller capital base. EBITDA, as we have already shown above, has no Company B is more valuable than company A and will mathematically logical connection to value. trade for a higher multiple of EBITDA every year. Why would Having told you all this, I will be the first to admit that an investor pay the same value for company A when company PE firms are generally aware of these handicaps—they are, B is worth company A plus more cash? If you follow the logic, after all, among the world’s most financially sophisticated then it makes no sense to think of companies as trading for investors—and they find ways to work around these short- multiples of EBITDA—otherwise, simple arbitrage opportuni- comings. For example, they put a heavy hand on spending ties would be plentiful. Everything else equal, a company that capital—it’s hard to come by—and they cover EBITDA’s generates more cash flow, a higher return on capital, and more blind spots by tracking other metrics, such as working capital EVA is worth more than another company with the same turnover, capital expenditures, or return on capital. But PE EBITDA. The conclusion? EBITDA by itself is an unreliable firms can do that only by overruling what EBITDA is saying, way to measure value. and thereby adding complexity and ambiguity to the manage- ment equation. EBITDA’s Failures as a Management Tool There is a better way. Instead of rationing capital, charge Because of its valuation shortcomings, EBITDA can also lead for it. Instead of following many metrics, start with a single, to bad decision-making. Among its worst shortcomings are overarching score—namely EVA—and use other metrics to these: explain the factors that contribute to EVA. EBITDA does not encourage discipline around solicit- ing or investing capital. Managers need never worry about Why EVA Is a Better Management Tool generating a decent return on capital or even a return of the Start with this: EVA is directly linked to value by the basic original capital investment because capital, in the EBITDA finance concept of net present value. To be specific, the present world, is a free resource. value of a forecast for EVA is always identical to the net pres- EBITDA ignores the value of managing assets and ent value, or NPV, of the forecast cash flows. By deducting the accelerating asset turnover, which results in the release of capital charge, EVA automatically sets aside the profit that must excess capital. be earned in each period to recover the value of the capital that EBITDA systematically understates the value of has been invested or will be invested. And this means that EVA outsourcing. Consider a company that sells its technology always discounts to the premium above, or discount to, the assets and converts to third-party cloud operations. Profit-and- capital invested in the business. To increase EVA is, by definition, loss (P&L) costs increase to pay for the outsourced services, to increase a company’s NPV, share price, and total shareholder which reduces EBITDA. But EBITDA ignores the benefit of return. Nothing of the sort can be said for EBITDA. selling the associated assets and releasing capital. A goal to increase EVA thus provides managers with the EBITDA overstates the value of vertical integration. correct incentives to create value—in any business—by going Why ever farm out production or distribution, and give up down any of these paths: some margin? The correct answer is that shedding capital may Operating Efficiently: Te first imperative EVA trumpets be worth more than losing the margin. But again, EBITDA is to cut costs and raise prices; that is, to find ways to raise is blind to that way of creating value. profits without raising capital. Granted, there’s no specific EBITDA favors higher-margin products and services, advantage to EVA here; almost all performance measures regardless of the additional capital those lines may need encourage such moves. when compared to lower-margin lines. Managing Assets Effectively:EVA is the only profit EBITDA sees no benefit in lowering a company’s tax performance measure that fully and correctly increases when bill or deferring taxes or making use of loss carryforwards. balance sheet assets decrease. EVA calls on managers to With EBITDA, there’s never a value to selling or exiting streamline supply chains and accelerate asset turnover as a a business, as long as it has any cash profit. In reality, selling way to reduce capital. It tells them to prune marginal plants, or exiting poorly performing and time-sapping units and products, and markets, and to exit businesses that aren’t cover- focusing attention on the remaining ones can add a lot value. ing the cost of capital—even if this means forfeiting sales,

104 Journal of Applied Corporate Finance • Volume 31 Number 3 Summer 2019 EBITDA, or profit margin. EVA also disciplines managers to ties. Because accountants treat R&D as an expense, it gets invest new capital carefully, conservatively, and imaginatively, managed as an expense. because they face a continuous, ongoing charge for using it. With EVA, the treatment of such investments is totally Growing Profitably: EVA also rewards managers different. A company’s R&D is written off over a preset indus- that put more capital to work to innovate, scale, and fuel try-specific period, and the cost of capital is applied as a charge growth, so long as the return on the capital exceeds the cost of to the outstanding accumulated R&D spending balance (which raising the capital. And unlike return on investment (ROI), is added to capital). This way, managers are far more willing EVA increases when managers pursue all profitable growth to increase their research budgets as they see promising and opportunities with returns above the cost of capital, even perhaps fleeting opportunities emerge—because they know if those returns are projected to be lower than the ROI the they have the time needed to make the investment pay off. firm is currently earning. EVA gets the incentives right, at But in exchange, managers also know they are on the hook the margin, on new investments and new decisions, and for recovering the investment and earning a decent return on without the distortions arising from legacy decisions or it over time, because they are charged for it even into future legacy capital. periods. Managers accordingly start to manage their R&D and Optimizing Tradeoffs:Managers can also add value by allocate resources to it as a strategic variable rather than setting making consistently better choices. EVA helps by distilling it at a traditional budget level. Depending on the company, this and combining all the pluses and minuses cutting across the approach can be a significant source of added value, while it also income statement and balance sheet into a single net score of makes EVA an even better measure of performance. added value. It guides managers to decisions that might never Much the same applies to advertising and promotion occur to them if EBITDA—or EBITDA and a grab bag of expenditures—for example, those incurred to launch a business other metrics—dominated their thinking. or build a brand. With EVA, these investments are also written As one example, EVA increases when outsourcing off over time with interest charged on the balance. Managers decisions reduce the total sum of operating costs and capital who are paid to increase EVA suddenly start to spend marketing costs. EVA also rises when the proceeds from selling a line resources against the life cycle value of customers rather than of business, invested at the cost of capital, produces more against a preconceived budget. They eagerly and aggressively profit than continuing to run it. A manager can also choose build valuable franchises rather than getting trapped into short- strategies by their potential for EVA. For example, is a lower- term thinking. growth, higher-rate-of-return strategy more valuable than a Consider one last example. When using EVA, restructuring lower-return, higher-growth path? The answer is, whichever charges are added back to earnings and added back to capital. one is expected to generate the most EVA. Many companies With that rule, a restructuring adds to EVA if the benefits, in find decisions like these challenging, and often reach the terms of streamlining costs and redirecting capital, exceed the wrong conclusions. But EVA deftly navigates the crosscur- cost of any new capital invested in the restructuring. A restruc- rents and resolutely points to the right answers. turing is no longer an admission of failure to be avoided. It can EVA widens its lead over EBITDA by systematically be a proactive opportunity to invest in a positive-NPV project, applying a set of corrective adjustments that are designed to one that managers will eagerly pursue. repair defects in accounting.1 Accounting rules, as already The adage “what gets measured gets managed” is true. noted, require companies to expense research and develop- By crafting a set of rules to remedy accounting illusions and ment (R&D) outlays. This ultra-conservative treatment can measure EVA with greater accuracy, a PE firm can mold the deter managers from boosting R&D budgets even when behavior of its management teams in positive ways that create profitable opportunities are in front of them, for fear of the value and discourage them from pursuing suboptimal decisions. upfront hit to GAAP profits. Teaching a management team about EVA and the rules used Expensing R&D also ironically relieves managers of to compute it, and how they can move the EVA needle, does accountability for it. In most companies, R&D just gets take some time and effort.2 But it is a highly EVA-positive factored into budgets at an established level, and managers investment. It is a proven way to improve financial literacy and can spend up to that level with no associated charges or penal- establish a common language across an organization—one

1 For a discussion of the rules and the decisions they induce, consult “The EVA Mea- 2 A successful adoption of EVA also requires software tools to compute, analyze, surement Formula,” by Bennett Stewart, available at https://www.issgovernance.com/ value, and report on EVA, per the specific rules chosen to measure EVA. ISS licenses solutions/iss-analytics/iss-eva-resource-center/. software solutions for just this purpose, which are easy to implement, configure, and use.

Journal of Applied Corporate Finance • Volume 31 Number 3 Summer 2019 105 Figure 1 Enterprise Value vs. EBITDA

Enterprise Value vs. EBITDA 2

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Valuation Margin (Enterprise Value/Sales)

0 10 100 0 0 0 100 10 A arin ASale that speeds decisions, enhances communication, promotes The correlation between EBITDA and EVA among those teamwork, and supports delegating decisions to those closer firms is just 30%. Put another way, a regression of EVA to to the action. EBITDA has an R2 of just 9%. The two measures are only In sum, EVA, when set against EBITDA, is a far more slightly correlated. For all the reasons outlined in the paper, comprehensive, cohesive, and value-based metric and manage- there is a great difference between EVA and EBITDA. Our ment technique.3 PE firms would be wise to use it to measure effort next was directed at determining if one of them is a value, and to guide and motivate managers, in their portfolio better measure of value. We began by looking at the corre- companies. lation between EBITDA and Enterprise Value in Figure 1, which plots EBITDA versus Enterprise Value; both variables EBITDA versus EVA Test Results have been divided by sales, which makes it possible to compare EVA clearly trumps EBITDA as a management technique. companies of different sizes.5 It’s a cloudy picture. The disper- But does it beat EBITDA as a measure of stock market sion is so great that a regression of Enterprise Value to EBITDA values? produced an R2 of only 9%. Companies plainly do not trade at To test this proposition, we analyzed the relationships any consistent multiple of EBITDA. Of course, analysts don’t between EBITDA, EVA, and enterprise values for Russell look at valuations relative to the whole market, but relative to 3000 companies as of March 12, 2019, excluding financials, an industry. We’ll come back to that a little later. real estate, utilities, smaller biotech firms, and companies To examine the correlation between EVA and Enterprise with less than $100 million in sales. This left us with 1,773 Value we need an intermediate step because, in theory, EVA companies.4

with sales under $100 million, and 37 companies with bad or missing data. 5 Technically, the correlations and regressions were performed between the ratios 3 For a more complete description of the EVA management model, consult Best of Enterprise Value/Sales and EBITDA/Sales. Dividing by sales was necessary to size Practice EVA, a book by Bennett Stewart (at Amazon, https://www.amazon.com/Best- adjust the variables and eliminate the spurious correlation that arises because larger Practice-EVA-Definitive-Maximizing-Shareholder/dp/1118639383. companies tend to generate more EBITDA and trade for larger values. We also observed 4 There were 2,975 companies in the Russell “3000” as of the test date. We that Enterprise Value/Sales ratios tend to be smaller for larger, more mature firms. The eliminated 210 financial firms, along with 75 utilities, 211 REITs and real estate devel- regression model therefore also included a “Size” variable (the natural log of the average opment companies, 219 biotech companies with sales under $1 billion, 138 companies of sales and capital), which entered with a statistically significant negative coefficient.

106 Journal of Applied Corporate Finance • Volume 31 Number 3 Summer 2019 Figure 2 MVA Margin vs. EBITDA Margin

MVA Margin vs. EBITDA Margin 2

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MVA Margin (MVA/Sales) 0 10 100 0 0 0 100 10

10 A arin ASale

does not discount to value per se. It discounts to the value Increasing MVA is thus the real key to creating wealth, added—that is, to the spread between a company’s Enterprise adding to franchise value, and increasing the firm’s NPV, all Value and the Capital it has invested to produce the value. We at the same time. Increasing MVA is also the key to driving refer to this spread as “MVA,” or Market Value Added, where: shareholder returns.6 The truly important question, then, is not whether MVA = Enterprise Value – Capital EBITDA explains Enterprise Value, but whether EBITDA explains MVA. The short answer is no, not at all. A company with a $1 billion Enterprise Value (market A regression of size-adjusted MVA to EBITDA produces value of equity plus debt), for example, that has $600 million white noise, the scattered diagram shown in Figure 2, with of total (book) capital on its balance sheet has an MVA of an R2 of just 4.8%. EBITDA is almost perfectly uncorrelated $400 million. with MVA, just as finance theory predicts, because EBITDA MVA is significant for three main reasons: ignores the capital side of the wealth equation. 1. MVA measures the owners’ accumulated wealth; it is We expect EVA to be much better at predicting MVA the spread between the total money put into a business and because, as mentioned, a company’s net present value, or the total value coming out of it. MVA, is mathematically equal to the present value of the 2. MVA represents franchise value; it’s the valuation EVA profit it is projected to earn. In the regression we used premium above total invested capital resources that is attrib- to test this proposition, we used a firm’s prior year’s EVA as a utable to the firm’s distinctive organizational capabilities and proxy for its projected EVA. In effect, we assumed that each other intangible assets. firm’s EVA will persist at its current level forever. It’s a gross 3. MVA measures the firm’s aggregate NPV. MVA is a summing up in the market’s mind of the net present value of 6 The mathematical link between EVA, MVA, and shareholder returns asserted here has been derived and tested, and is available in a separate ISS white paper, “The Link all capital projects, those a firm already has in place plus those Between TSR and EVA,” available at https://www.issgovernance.com/solutions/iss-ana- projected to materialize down the road. lytics/iss-eva-resource-center/.

Journal of Applied Corporate Finance • Volume 31 Number 3 Summer 2019 107 Figure 3 MVA Margin vs. EVA Margin

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0 Valuation: MVA Margin (MVA/Sales) 120 100 0 0 0 20 0 20 0 0 0

10 rofitabilit VA arin VASale simplification that ignores the potential for growth in EVA, Second, when EVA is zero or near zero, MVA tends to be but it shows how well EVA performs compared to EBITDA close to zero, too. Just as finance theory predicts, investors are with the same constraint. unwilling to pay much if any premium value for firms that The regression of MVA to EVA,7 as shown in Figure 3, deliver only a basic, break-even rate of return on their capital. shows an R2 of 21.4%. That’s not terrific—but this is a simple They will only pay for the book capital in the business. This model, applied regardless of industry and ignoring growth shows that the cost of capital we have computed is a real cost, potential. And the analysis demonstrates that EVA is fundamen- with a real market impact. Until a firm earns it, it does not tally more correlated–-in fact, five times as correlated—with create wealth and it cannot produce exceptional shareholder enhancing NPV and creating wealth than EBITDA. returns. The correlation between EVA and MVA, however, is Observe also that the companies falling short of their cost much stronger and more interesting when firms are clustered of capital and that are producing negative EVA tend to trade into groups. In this analysis, we ranked companies low to high for an MVA near zero, no matter how negative EVA gets to be. by their EVA/sales ratios, then we assigned them to 35 bins of This last finding, surprising at first hearing, is a sign of 50 companies each, thus covering 1,750 firms (or all but the market sophistication. Investors have learned from experience 23 companies with the very highest EVA-to-sales ratios). We that managers in negative EVA businesses feel pressure and then computed the median EVA/sales and MVA/sales ratios respond. They restructure operations, redirect resources, and for each of the 35 bins and plotted the pairs shown in Figure rethink strategies, or they liquidate assets or sell the company. 4, with the following conclusions: They manage to raise EVA to zero or near zero, or realize First, note that once EVA turns positive, EVA multiplies something close to the net book value of their assets in a sale. into MVA along a straight line. There’s something else going on, too. The negative EVA group also contains emerging start-up companies that are not yet covering their cost of capital but are forecast to reach that 7 As with the EBITDA, the variables are common sized, by dividing by sales, and the regression model includes a term for company size, as MVA/Sales ratios tend to be mark someday. smaller for larger, more mature firms.

108 Journal of Applied Corporate Finance • Volume 31 Number 3 Summer 2019 Figure 4 Median MVA/Sales vs. EVA/Sales for Groups of 50 Companies

Median MVA/Sales vs. EVA/Sales for Groups of 50 Companies 00

00

00

300

200

100 Valuation: MVA Margin (MVA/Sales)

0 0 0 30 20 10 0 10 20 30 rofitabilit VA arin VASale 100

200

For whichever reason, the market sets a floor on the value Valuations within Industry Groups of negative EVA companies considered as a portfolio.8 This is The regressions we’ve reviewed so far assume that investors another critical valuation insight that EVA gets but EBITDA assign the same multiples to all Russell 3000 firms regardless does not. of industry. It’s more realistic to assume that valuation multi- Given this relationship, we reran the regression of MVA ples cluster within industry groups. We therefore assigned to EVA by setting the value for EVA to 0 whenever a firm’s all 1,773 companies into 44 groups using standard industry EVA was negative. In effect, we assumed that the expected classification (SIC) codes and performed the same regressions long-run EVA of all negative EVA companies is zero. It’s a within each group. bold assumption, but does it work? As an example, here is the plot of size-adjusted EBITDA The regression 2R did drop a tad, from 22.4% to 21.9% versus Enterprise Value for the 34 companies in the Aerospace (because there is, in fact, a slight valuation penalty as EVA and Defense industry. There is an evident upward slope becomes more negative), but in exchange, the coefficient on connecting the dots. EVA increased from 17.6 to 18.5 and the t-statistic rose from The 2R is 42%; the coefficient on EBITDA is 17.6, 18.2 to 19.5 (99.9999% confidence). The new model is better. with a t-stat of 4.8 (significant at the 99.9% confidence level). It more closely fits the actual line connecting EVA and MVA. Enterprise Values tend to increase as a multiple of EBITDA It sets a more positive and significant slope to EVA when in this industry, as in many others. The statistics confirm it: EVA is positive and sets the slope on EVA to zero when EVA clustering companies by industries makes sense. is negative.9 We use this version of the model in the industry Good as that is, EVA is much better. A regression of size- regression runs discussed below. adjusted MVA to EVA has an R2 of 62%10 with a coefficient on EVA of 32.8 and t-stat of 6.6. 8 This is not a new phenomenon or peculiarity of the current market. The relation between EVA and MVA documented in this study was also documented in 1991 with the publication of The Quest for Value, by Bennett Stewart. The assumption that negative R2 a tad, but the coefficient and t-stat on it were much smaller and much less significant EVA companies as a group will rebound, restructure, or sell and generate a long-run than on the EVA positive variable we chose to ignore it. breakeven for EVA is apparently a permanent feature of the valuation landscape. 10 Technically, the R2 of size-adjusted EVA with MVA was 58%, but it is 62% versus 9 We also tested a second EVA variable that was set to zero when EVA was positive, Enterprise Value because a portion of the portion of the variation in Enterprise Value is in other words, it was populated only when EVA was negative. Adding it increased the due to variation in Capital. Consult the Technical Appendix for more details.

Journal of Applied Corporate Finance • Volume 31 Number 3 Summer 2019 109 Figure 5 Aerospace and Defense: Enterprise Value vs. EBITDA

Aerospace and Defense: Enterprise Value vs. EBITDA 10

9

3

2

Valuation Margin (Enterprise Value/Sales) 1

0 0 10 20 30 0 0 0 A arin ASale

EVA, note, packs almost twice the punch of EBITDA. • The median R2 of the correlation with Enterprise A 1% increase in a firm’s EVA/sales ratio tends to increase Value across all industries was 32% for EBITDA and 47% its MVA wealth premium by 32.8% of sales; a 1% increase for EVA. The EVA advantage is even larger—a median R2 of in its EBITDA-to-sales margin increases Enterprise Value by 58% versus 38% for EBITDA—when we limit our analysis only 17.6% of sales; it’s half as helpful. But not only that, to the 29 industries that contain 20 or more companies and EBITDA increases a firm’s Enterprise Value while saying where EBITDA or EVA are significant valuation variables. In nothing about how much capital was required to do it. EVA, those cases, EVA thus has approximately 15% to 20% more however, increases MVA. It tells us how much the firm’s Enter- explanatory power. prise Value increased above the capital that the firm invested, • EVA was more significant than EBITDA in 22 indus- which is a much more significant result. tries, and EBITDA in 8. And three of those eight industries We ran the same regressions for all 44 industries. As contained very few observations: Biotech (with more than $1 summarized in the Appendix, we found the following: billion in sales) was represented by only 12 companies, Inter- • Neither EVA or EBITDA performed well in nine net Services by 11, and Wireless Communication by just 9. industries, including Tech Hardware, Software, Pharma, Life • EVA was significantly better in most capital-intensive Sciences, Internet Media, and Health Care Equipment and industries, such as Auto and Suppliers, Oil and Gas, Media, Supplies. In dynamic businesses like these, the percentage of Communication Equipment, Construction, Household Enterprise Values attributable to current earnings and cash Durables, Paper and Packaging, and Semiconductors. That’s flow—what we call “current operations value,” or COV— expected, because EVA explicitly recognizes the cost of capital. tends to be pretty low (in some cases, as little as 25%), and • EVA also outperforms EBITDA in Commercial Services the value attributable to what we call “future growth value” and Supplies, Food and Beverage Retailing, Specialty Retail, quite high. In such cases, the current levels of EBITDA and and Professional Services, which might be surprising; after all, EVA are likely to fail to convey much information.11 these are businesses that aren’t especially asset intensive. The

11 In the analysis for the tests for these nine industries with low COV and high FGV, reason to expect that EVA would significantly outperform EBITDA since EVA discounts to we did not attempt to model future growth expectations. Had we done so, there is every NPV while EBITDA does not.

110 Journal of Applied Corporate Finance • Volume 31 Number 3 Summer 2019 Figure 6 MVA Margin (MVA/Sales) vs. EVA Margin (EVA/Sales)

MVA Margin (MVA/Sales) vs. EVA Margin (EVA/Sales) 10

2 Valuation: MVA Margin (MVA/Sales) 0 1 10 0 10 1 20 2

2 rofitabilit VA arin VASale cost of capital, though, can still be a considerable charge and we have documented in this paper follow as a natural an important valuation factor relative to the meager margins by-product. that these companies typically work with. The finding that EVA dominates EBITDA as a measure Using EVA to Determine Enterprise Value of stock market value will no doubt surprise many. After all, Given that EVA is an effective valuation metric, how, specif- sell-side research reports and the business media are rife with ically, can PE firms use it to measure value? After all, EVA references to EBITDA and notably scarce on EVA. But our does not discount to share price or market value per se; EVA findings don’t imply or require that investors literally compute discounts to net present value—that is, to MVA, which is a or analyze EVA in determining value. Some investors do—ISS company’s Enterprise Value minus the Capital invested in its provides EVA-based research to an expanding clientele of insti- business: tutional investors, for example—but many do not explicitly consider EVA. No matter. MVA = Enterprise Value – Capital As has been noted, the present value of EVA and the net present value of cash flows are mathematically identical. So By rearrangement, Enterprise Value is: long as most investors measure intrinsic value by analyzing and discounting cash flows (or indirectly, by looking at indica- Enterprise Value = Capital + MVA tors that help them gauge the magnitude, quality, timing, and risk of cash flows), then EVA and MVA, and by extension, And MVA, the company-wide NPV, is equal to the EVA and Enterprise Value, will be strongly correlated. present value of EVA: This is a very important point. One does not have to believe in “EVA” to think it is sensible to use EVA. As Enterprise Value = Capital + The Present Value of EVA long as one subscribes to the view that valuations follow discounted cash flows, the significance of EVA as a valua- The formula says that the enterprise value of a tion metric and the correlation to creating wealth that business viewed as a going concern is the amount of capital money put into it plus the present value of the

Journal of Applied Corporate Finance • Volume 31 Number 3 Summer 2019 111 EVA profit projected to come out of it. EVA is the reason, EVA Is a Superior Management System and the only reason, a company is worth more, or less, EVA can not only estimate value, but can also play an active than the money put into it. role in helping PE firms to create value. How? By empower- The capital part is easy: it’s the firm’s net assets as of ing the management teams in portfolio companies to make the valuation date.12 The present value of EVA is harder. better decisions. An analyst begins by preparing a P&L and balance sheet The idea, in a nutshell, is to get the teams to focus on projection, taking account of the developments they foresee increasing EVA as their paramount financial goal and to use for revenues, operating margins, taxes, working capital it broadly. Managers should use EVA, first of all, to measure turnover, capital expenditures, and the like. The next step is value and make decisions by projecting it and discount- to compute the EVA profits implied by the financial forecast, ing it to measure NPV; second, as a check for reviewing and then to discount the projected EVA to a present value performance and benchmarking with peers; and third, as at the firm’s cost of capital. Putting the two together—the a possible yardstick for metering bonus pay. Using EVA in firm’s capital and the discounted EVA value—yields the this comprehensive way is what makes it simple, accountable, estimate of the firm’s intrinsic Enterprise Value. and adaptable. Once again, the EVA procedure produces the same It’s simple because one metric threads through and unites valuation as discounting the cash flows. For a given projec- all applications. There’s no need for using cash flow calcu- tion, EVA does not give a new answer, it is the same lations for valuations and capital budgeting purposes and answer—which is essential, of course. Still, there are very other sets of metrics for other applications. That’s a common good reasons to prefer using EVA for valuations instead of solution that often needlessly complicates practice. By using cash flow. EVA, measures like cash flow, ROI, and EBITDA can be For one thing, a projection of EVA reveals how much retired. They are redundant and inferior to just keeping all value is being added or lost in each projection period. If eyes focused on the goal of increasing EVA.13 a forecast shows that EVA will be zero or close to it, for The EVA model also introduces much stronger account- example, there is no value added over the plan horizon. ability for results. If managers want more capital, and succeed No matter what any other measures suggest, an analyst in getting it, they must deliver more EVA, period. They must will instantly understand why that business is worth just cover the cost of the capital they request and invest. When the book value of the capital put into it. And if an analyst they find that they are so visibly responsible for making good models out several forecast scenarios, the one that produces on their promises, managers respond by scrutinizing decisions the more rapid expansion in EVA is immediately recogniz- with much greater intensity and thinking about alternatives able as the one that is worth more, and, again, irrespective with much more creativity. of what any other measure may say. EVA also increases a company’s agility. If the goal to An analyst also can directly trace the forecast for EVA increase EVA is paramount, then every other measure can to its underlying assumptions. An improvement in working flex (except for mission-critical goals, such as safety, health, capital turnover, for instance, appears as a line-item reduc- environmental, and strategic objectives). Managers no longer tion in the capital charge and thus as a directly measurable are straitjacketed into meeting targets for micro-metrics. They improvement in EVA. Whether the assumption covers P&L can use common sense and adapt plans and adjust decisions as costs, or revenues, or capital utilization, the impact on EVA circumstances dictate. For example, they won’t keep investing is clear, and thus the impact on value is clear, too. capital to meet growth or margin targets when the return on In sum, EVA not only gives a valuation answer; it gives the incremental investment is no longer attractive. Instead, insights into why the answer is the answer. Thus the valua- they will change course and drive the most value by creat- tion is not just a black box; it reveals and quantifies the ing the most EVA. In short, they will aim to win games, not key factors that are determining the value. Perhaps the best mindlessly follow game plans. way to describe EVA, then, is that it is the simplest and most effective way to estimate and understand a company’s intrinsic cash flow value.

13 EVA is nowadays a much more effective analytical tool since it’s been converted into a series of performance ratios and a companion ratio analysis framework. It’s de- 12 Net assets must be adjusted to reflect the corrective adjustments EVA applies. The scribed in detail in the book, Best-Practice EVA, available on Amazon, and at a high net assets exclude excess cash, for example, and include the remaining balance of R&D level, in the ISS white paper, “The Four Key EVA Performance Ratios,” available at spending carried over from prior years. https://www.issgovernance.com/solutions/iss-analytics/iss-eva-resource-center/.

112 Journal of Applied Corporate Finance • Volume 31 Number 3 Summer 2019 EVA thus differs from EBITDA in another, very impor- establish a common scorecard that will apply across their tant way. It is a technique that PE firms can adopt to accelerate entire portfolio of businesses, no matter how diverse they are. the creation of value within their portfolio companies. No other measure, or set of measures, can do that.

A Special EVA Solution for PE Firms Closing Comment For all of EVA’s advantages, there are two caveats: PE firms For many, it is an article of faith that companies are worth are typically judged by the internal rate of return (IRR) of a certain multiple of EBITDA. The evidence presented here their investments; they also must ensure that their portfolio strongly refutes that notion. Stocks trade on cash flow, net of companies are able to service the debts taken when they are investment—or better, on the prospects for EVA, for gener- acquired. It may therefore seem that ROI and EBITDA or ating economic profit above the cost of capital—as economic cash flow metrics are needed and would be superior to EVA logic suggests they should. Enterprise or EBITDA multiples given those constraints, but that is not so. do not determine value but are derived from it. The optimal solution is still to use EVA for managing Despite the findings of this paper, it is unlikely PE firms and valuing businesses, but with a simple modification: EVA will abandon EBITDA; there’s too much institutional inertia should be measured using an artificially high cost of capital, behind EBITDA. But at the very least, PE firms should a rate well above actual market expectations, as high as 12% consider using EVA to complement EBITDA in due diligence or more, for example. Posting an after-tax charge on capital investigations and company valuations, and for reviewing the as great as 1% a month or more tells managers to work extra performance, plans, and decisions of portfolio companies hard to sweat capital out of the balance sheet. A high hurdle while they hold them. rate also pushes back on projects that otherwise would be The biggest payoff, however, is likely to come from accepted, leaving only the very highest-returning investments encouraging portfolio companies to “adopt” EVA. By this we to pass muster, and a lot of cash flow to repay debt in the wake. mean the management team is trained about EVA and how to Doing this is not without a sacrifice. Imposing an artifi- use it. They are equipped with tools that enable them to evalu- cially high cost of capital chokes investments that would be ate the performance of the company and its lines of business, favorably valued in the stock market. Still, if cash constraints and simulate the value of plans and decisions, through the lens are real, and if PE firms are judged by IRR, then that cost of EVA. An EVA-capable team is apt to make better decisions, is unavoidable, and they must pay it with or without EVA. surface more valuable plans and investments, react faster and EVA, however, is the best way to recognize the cost and enable more intelligently to changing circumstances, and acceler- managers to work around it. ate the creation of value that is at the very heart of the PE If applying such a high cost of capital rate turns what mandate. seems a profitable business into an EVA loser, that is of no consequence. The goal with EVA is always to increase it. Bennett Stewart is Senior Advisor at Institutional Shareholder Making a negative EVA less negative is just as valid a way to Services (ISS). In 1982, he and Joel Stern formed the financial consult- improve performance and create value as it would be to take ing firm of Stern Stewart & Company. In 2006, he became CEO of EVA an EVA that is positive and make it more positive. It’s the Dimensions LLC, which was recently acquired by ISS—thus ensuring change that counts, not the level. that EVA will remain a definitive measure of financial quality worldwide. The goal of increasing EVA can be applied to any business, regardless of its starting point, regardless of legacy assets or liabilities, regardless of how much or little capital intensity is A technical appendix explaining the regression models and required by the business model—another reason why EVA statistical tests is available from the author upon request at should hold great appeal to PE firms. They can use EVA to [email protected].

Journal of Applied Corporate Finance • Volume 31 Number 3 Summer 2019 113 Appendix 1: The Industry Regression Results Legend EVA better EBITDA regression: EBITDA better Enterprise Value/Sales = a + b x EBITDA/Sales + c x SIZE + e Neither better EVA regression: Neither good Enterprise Value/Sales = Capital/Sales + a + b x EVA/Sales + c x SIZE + e <20 observations

Industry Group # Companies Adj R2 Variable t-stat Size t-stat

1 Aerospace & Defense EBITDA 34 42% 17.7 (4.8) -0.43 (-2.5)

EVA 61% 32.8 (-2.7) -0.37 (6.6)

2 Airlines EBITDA 12 57% 6.7 (2.6) -0.04 (-0.5)

EVA 60% 10.4 (0.9) 0.06 (2.9)

3 Auto & Suppliers EBITDA 29 32% 9.2 (3.3) -0.16 (-1.4)

EVA 46% 17.5 (-1.1) -0.11 (3.9)

4 Biotech EBITDA 12 25% -10.1 (-2.0) 0.49 (0.6)

EVA 8% -9.4 (-0.6) -0.49 (-1.1)

5 Chemicals EBITDA 60 31% 8.1 (5.3) -0.13 (-1.2)

EVA 25% 12.2 (0.3) 0.03 (4.1)

6 Commercial Services and Supplies EBITDA 55 22% 6.7 (4.1) -0.06 (-0.3)

EVA 73% 26.7 (0.9) 0.10 (8.9)

7 Communication Equipment EBITDA 33 38% 8.4 (4.6) -0.07 (-0.3)

EVA 60% 18.1 (0.4) 0.06 (8.7)

8 Conglomerates and Machinery EBITDA 103 68% 16.5 (14.8) -0.18 (-2.9)

EVA 68% 25.1 (-2.2) -0.13 (12.1)

9 Construction EBITDA 62 68% 16.1 (11.1) -0.09 (-1.0)

EVA 76% 26.9 (-0.3) -0.03 (10.6)

10 Diversified Consumer Services EBITDA 19 -3% 2.8 (0.4) -0.83 (-1.2)

EVA 14% 14.4 (-1.3) -0.81 (1.6)

11 Diversified Telecom Services EBITDA 15 57% 11.7 (4.6) -0.49 (-2.4)

EVA 79% 30.5 (-3.3) -0.44 (3.0)

12 Electrical Equipment EBITDA 26 -9% 0.1 (0.1) -0.03 (-0.1)

EVA 33% 3.2 (-0.3) -0.06 (1.0)

13 Electronics and Office Equipment EBITDA 56 45% 11.9 (6.1) -0.48 (-3.1)

EVA 48% 23.8 (-1.9) -0.29 (5.4)

14 Energy Equipment and Supplies EBITDA 58 6% 2.8 (2.3) 0.07 (0.6)

EVA -36% 21.4 (-0.7) -0.11 (3.5)

15 Entertainment EBITDA 23 0% 4.5 (1.3) -0.01 (0.0)

EVA 29% 28.9 (-1.1) -0.24 (3.6)

16 Food and Beverage (ex Tobacco) EBITDA 52 65% 18.9 (9.8) -0.42 (-4.0)

EVA 73% 26.3 (-3.8) -0.34 (10.3)

17 Food and Staples Retailing EBITDA 21 41% 12.0 (4.0) -0.02 (-0.6)

EVA 66% 29.4 (-1.4) -0.03 (5.2)

18 Freight Transportation EBITDA 45 88% 10.8 (17.3) 0.14 (2.1)

EVA 61% 20.8 (1.2) 0.16 (5.2)

19 Health Care Equipment and Supplies EBITDA 70 4% -2.4 (-0.6) -0.57 (-1.5)

EVA 4% 20.6 (-3.0) -0.96 (2.6)

20 Health Care Providers EBITDA 63 17% 5.0 (1.3) -0.73 (-3.6)

EVA 49% 37.5 (-3.4) -0.56 (5.7)

21 Hospitality EBITDA 39 9% 4.4 (2.2) -0.26 (-1.6)

EVA 22% 23.6 (-1.4) -0.21 (6.1)

22 Household and Personal Care EBITDA 23 42% 20.0 (4.2) -0.24 (-1.4)

EVA 64% 31.0 (-2.5) -0.30 (7.4)

114 Journal of Applied Corporate Finance • Volume 31 Number 3 Summer 2019 Appendix 1: The Industry Regression Results continued

23 Household Durables EBITDA 46 2% 7.9 (1.3) -0.47 (-1.6)

EVA 32% 19.5 (-1.6) -0.38 (2.2)

24 Internet Media EBITDA 16 -13% 0.2 (0.0) 0.22 (0.3)

EVA -33% -1.5 (0.5) 0.27 (-0.2)

25 Internet Retail EBITDA 22 29% 13.8 (3.3) -0.33 (-1.1)

EVA 20% 15.6 (-0.5) -0.18 (2.3)

26 Internet Services EBITDA 11 74% -32.0 (-5.5) 2.82 (2.8)

EVA -47% -64.4 (-0.4) -0.74 (-0.4)

27 IT Services EBITDA 61 44% 15.0 (6.3) 0.15 (0.6)

EVA 54% 23.0 (0.9) 0.19 (6.3)

28 Leisure EBITDA 16 -10% 2.3 (0.8) 0.01 (0.1)

EVA 1% 15.0 (-0.3) -0.04 (3.6)

29 Life Sciences EBITDA 21 6% 6.8 (1.7) -0.38 (-0.7)

EVA -1% 6.5 (0.2) 0.10 (1.1)

30 Media EBITDA 45 35% 9.5 (5.1) -0.27 (-1.4)

EVA 62% 29.4 (-1.5) -0.21 (9.8)

31 Metals and Mining EBITDA 33 59% 11.1 (6.9) -0.27 (-1.6)

EVA 47% 9.6 (-1.2) -0.23 (1.8)

32 Oil & Gas Exploration and Production EBITDA 99 29% 5.1 (6.2) -0.14 (-1.0)

EVA 52% 34.9 (0.3) 0.04 (3.6)

33 Paper and Packaging EBITDA 29 45% 9.3 (5.0) -0.08 (-0.8)

EVA 57% 9.5 (-0.6) -0.05 (3.2)

34 Pharmaceuticals EBITDA 30 -6% 0.9 (0.6) 0.04 (0.2)

EVA -22% 7.4 (-0.9) -0.17 (3.0)

35 Professional Services EBITDA 38 32% 14.9 (4.3) -0.10 (-0.3)

EVA 43% 26.4 (0.3) 0.11 (3.4)

36 Restaurants EBITDA 36 66% 22.2 (8.4) -0.77 (-3.1)

EVA 57% 27.9 (-2.6) -0.70 (6.6)

37 Semiconductors EBITDA 64 16% 9.7 (3.6) -0.52 (-1.9)

EVA 26% 18.4 (-1.7) -0.36 (5.1)

38 Software EBITDA 107 0% -0.7 (-0.3) -0.35 (-0.9)

EVA -4% 17.5 (-3.0) -1.07 (2.6)

39 Specialty Retail EBITDA 92 17% 5.5 (4.6) -0.08 (-1.1)

EVA 60% 23.6 (-1.6) -0.08 (10.4)

40 Technology Hardware EBITDA 18 8% 4.1 (1.2) -0.33 (-1.9)

EVA -3% 17.1 (-1.6) -0.26 (3.0)

41 Textile, Apparel, and Luxury Goods EBITDA 24 46% 16.3 (4.0) 0.07 (0.5)

EVA 59% 31.2 (-0.2) -0.03 (6.1)

42 Trading Companies EBITDA 40 93% 9.1 (22.8) -0.20 (-2.1)

EVA 96% 17.1 (-3.4) -0.23 (6.3)

43 Wireless Communications EBITDA 9 58% 11.4 (3.4) -0.55 (-2.3)

EVA -122% 398.6 (-1.1) -0.70 (0.8)

Journal of Applied Corporate Finance • Volume 31 Number 3 Summer 2019 115 Beyond EVA by Greg Milano, Fortuna Advisors

n early 2018, Institutional Shareholder Services (ISS), the well-known proxy advisory I firm, announced that it had acquired EVA Dimensions, an equity research firm that uses economic value added (EVA)1 to measure corporate performance and estimate a compa- ny’s intrinsic value. Following this acquisition, ISS also announced that in 2019 EVA would be featured in its research reports along with GAAP-based measures—and that in 2020 it would consider making EVA-based measurements part of the financial performance assessment meth- odology for its pay-for-performance model.2 Those of us who have been studying performance measurement and compensation design for decades applauded the news.

But not all were as enthused about this development, as discussed below. But it was a major advance in performance I recently found out when I attended a WorldatWork confer- measurement when it was launched about 30 years ago. ence in Colorado focused on trends in executive compensation But before getting into the specifics, let me provide some and performance measurement. Though many topics were context for what follows. In 2001, when Joel Stern and John discussed, a common thread running through many presenta- Shiely published The EVA Challenge: Implementing Value- tions was that EVA was undergoing a resurgence—and every Added Change in an Organization,3 they asked me to write expert warned that human resource professionals should the epilogue, which came to be titled “EVA and the ‘New be deeply concerned about its impending return. The most Economy.’” The authors wrote the book during the dotcom common complaint was about the complexity of the EVA bubble, and the epilogue was my early attempt to explain performance measure, but some also cautioned against its corporate valuation in situations where corporate investments tendency to encourage “underinvestment.” more often took the form of R&D and marketing expen- Yet, having implemented EVA with Stern Stewart for over ditures than traditional capital spending on buildings and ten years beginning in 1992, I can say with some confidence machinery. As I wrote back in 2001, “Do not be distracted by that EVA is a more effective way of guiding and motivating the values of new economy companies. The share prices may corporate managers to create value than traditional perfor- be realistic or they may be a dream; we do not know. However, mance measures. It was a substantial step forward in the …[a]t any reasonable percentage of prevailing valuations, this evolution of performance measurement in that it attempts would be an NPV-to-capital ratio that many ‘Old World’ to balance considerations about both “quantity” (or growth) companies would cherish.” and “quality” (rate of return, or profitability) within a single A year earlier, in 2000, I gave a speech at Stern Stewart’s measure. Sure, there are improvements that can be made to second European EVA Institute in Fiuggi, Italy that was later simplify EVA and encourage better behavior, which will be adapted into an article titled “EVA and Growth” and published in Stern Stewart’s EVAngelist magazine.4 As I pointed out in my speech, although EVA theoretically encourages all good 1. EVA is a registered service mark of Stern Value Management, Ltd. (originally by investments insofar as it rewards the delivery of returns above Stern Stewart & Co. in 1994) for financial management and consulting services in the area of business valuation, and is registered as a trademark by Institutional Shareholder Services Inc. (originally by EVA Dimensions LLC in 2008) for a number of uses. 3 Joel M. Stern and John S. Shiely, The EVA Challenge: Implementing Value- 2. Karame, Marwaan, “Prepare for This Pay-for-Performance Measure,” CFO.com, Added Change in an Organization (New York: Wiley, 2004). December 4, 2018. http://fortuna-advisors.com/2018/12/04/prepare-for-this-pay-for- 4 Milano, Gregory V., “EVA and Growth,” EVAngelist, Volume IV, Issue IV, Italy performance-measure/. 2000, pages 9-13.

116 Journal of Applied Corporate Finance • Volume 31 Number 3 Summer 2019 a weighted average cost of capital, with many clients I had Overview of EVA witnessed EVA stifling growth investment and causing manag- In the 1990s, EVA was all the rage. One would hardly have ers to place too much emphasis on cost efficiency and capital known that economic profit had been developed in academia productivity. The speech and article were my first attempts, over 100 years earlier. Of course, the formula for EVA reflected while I was still at Stern Stewart, at explaining the behavioral a specific definition of economic profit that was developed and reasons for these unintended consequences of an otherwise popularized by Stern Stewart & Co. EVA is simply Net Oper- good idea. ating Profit after Taxes (NOPAT) less a capital charge to reflect Then, in 2004, I joined the “Buyside Insights” Group of the expected return of the shareholders and lenders on the the Credit Suisse investment banking department shortly after capital they have committed to the company. But to adjust for they had acquired the HOLT® valuation framework.5 HOLT some of the idiosyncrasies of accounting, and presumably to is a highly sophisticated framework for valuation, which is to improve the quality of the performance measure, calculating say that it’s very complicated. It’s great for investors, who tend EVA requires a stream of adjustments to GAAP accounting to be a very numerate lot, but has proven to be cumbersome that make the metric significantly more complicated to under- for corporate management teams. Worth noting here, though, stand and implement. According to the Wikipedia page for is that HOLT is “cash-flow based,” so it doesn’t recognize EVA, there are over 160 potential adjustments.7 depreciation as a cost and assets don’t decline in value as they On the one hand, this plethora of adjustments in the get older. It was during this period that I realized that depreci- hands of corporate finance departments has made EVA more ation was at the root of one of the biggest problems with EVA. comprehensive and robust—but at the cost of making the By making new assets look more expensive than they really are, measure harder for managers to understand. And as a general and by creating an illusion of performance improvements as rule, if people do not understand a financial measure well, it those assets depreciate away, the conventional accounting for is much less likely to motivate their behavior—at least in the depreciation causes distortions in the timing of EVA—and of way it was designed to. virtually every return measure, including ROE, ROIC, and Along with the complexity, there is also a short-termism ROCE. I will come back to this later, but for now, suffice it problem that is potentially far more destructive to the pursuit to say that depreciation was a key to solving the puzzle of why of shareholder value. To understand why EVA motivates short- EVA appeared to be discouraging new investment. term behavior, let’s consider the three main ways that EVA It was these shortcomings of EVA that ultimately led our leads managers to increase value: Fortuna Advisors team to develop a better economic profit performance measure when we founded our corporate share- Motivation #1: Improving current performance by optimiz- holder value advisory firm in 2009. The process began with ing pricing, cost management, and capital utilization. extensive empirical testing to refine our ideas and develop a simpler economic profit measure that does a better job of Motivation #2: Investing in all new projects that generate tracking total shareholder return and, more important, strikes sufficient NOPAT to more than cover the capital charge. a better balance between delivering current performance and investing in the future. The result was Residual Cash Earnings Motivation #3: Harvesting low-return investments and (RCE), which was introduced here in the Journal of Applied diverting the resources toward EVA-enhancing activities. Corporate Finance in 2010.6 We have implemented RCE for many companies since then, in most cases customizing the measure (and often renaming it after the company) to fit different businesses and industries. 7 Wikipedia contributors, “Economic value added,” Wikipedia, The Free Encyclo- In the sections that follow, I will explain how both EVA pedia. Accessed August 21, 2019. https://en.wikipedia.org/wiki/Economic_value_add- ed. A list of common adjustments to EVA includes: (1) eliminating excess cash and the and RCE are calculated as well as how RCE differs from EVA NOPAT impact; (2) adjusting NOPAT for the change in provision for bad debts; (3) con- by providing management with the performance indicators verting LIFO inventory to FIFO; (4) removing all pension charges from NOPAT except the annual service cost, and treating underfunded pensions as debt (and vice versa); (5) and incentives to pursue an optimal balance of profitability capitalizing the present value of operating lease commitments and removing the financ- and value-adding investment. ing portion of leases from NOPAT; (6) capitalizing and amortizing R&D and certain mar- keting expenditures; (7) removing unrealized gains/losses on hedging-related derivatives; (8) removing minority interest effects; (9) permanently capitalizing (and removing from 5 HOLT® is a registered trademark of Credit Suisse Group AG or its affiliates in the NOPAT) unusual items including: a) impairment charges and asset write-offs, b) restruc- United States and other countries. turing and nonrecurring items, and c) gains and losses on sale of assets; and (10) charg- 6 Milano, Gregory V., “Postmodern Corporate Finance,” Journal of Applied Corpo- ing an adjusted cash tax amount by: a) applying a standard tax rate, b) adjusting for rate Finance 22, no. 2 (Spring 2010): 48-59. deferred taxes, and c) recognizing the tax benefit from deducting stock options.

Journal of Applied Corporate Finance • Volume 31 Number 3 Summer 2019 117 Figure 1 Comparing the Cost of Ownership of EVA vs. RCE

Cot of nerip VA Cot of nerip C

1 2 3 1 2 3

VA Capital Care epreciation A C Capital Care

VA eidual Ca arnin

1 2 3 1 2 3

In my experience, most EVA-driven companies do a fair year and then declines as the asset depreciates away. This invest- job on the first and third motivations, but the vast majority ment project contributes negative EVA for three years, slightly underinvest in the business, and so the second motivation positive EVA in years four and five, and sharply rising EVA doesn’t usually work out as intended. The result is often less in years six and seven after the asset is fully depreciated—and profitable growth and a tendency to cut expenditures related is essentially free. If we had a seven-year-old asset being held to maintaining and upgrading aging assets. This is known as together by rubber bands and shoelaces, we probably would “sweating assets,” and some finance managers commend such want to replace it. But it would sure hurt to see all that EVA tactics. Unfortunately for shareholders, though, our research disappear, replaced by negative EVA that takes four years to shows a negative relationship between sweating assets and TSR.8 turn positive again. So the natural response of many managers is to defer that replacement decision as long as possible, because Beyond EVA that’s what EVA is paying them to do. If they overcome this To build a better mousetrap, we sought a deeper understand- incentive to sweat old assets, they do so by putting the interests ing of the problems with EVA that we were trying to fix. It of the company ahead of their own (bonuses). was obvious that the ideal measure needed to be simpler than It’s easy to illustrate how a focus on continuously improv- EVA, with fewer adjustments to accounting; but it took me ing EVA can stifle investment. The two graphs on the left side the better part of a decade to figure out the ways in which EVA of Figure 1 illustrate the total cost of depreciation plus the was discouraging corporate investment. Now it seems so clear. capital charge (the top graph) and the EVA for this investment It is easiest to see the bias against capital expenditures (the bottom graph). by considering a single new investment of $1 million in an The biggest difference between RCE and EVA is that asset that has a five-year accounting life, and an average useful RCE doesn’t charge for depreciation—and because the service life of about seven years. Let’s assume that a conservative capital charge is based on gross assets, it doesn’t decline over forecast of free cash flow for the investment indicates a positive time. As can be seen in the two graphs on the right side of net present value and an IRR that is 1.6 times the weighted Figure 1, the cost of ownership is lower at the outset but average cost of capital. Finance theory suggests that this invest- stays flat even after the asset is fully depreciated. As a result ment would add nicely to the market value of the company. RCE is positive out of the gate and actually declines a bit Under EVA, the cost of owning an asset is the sum of the in years six and seven when taxes rise (as the tax-deductible depreciation and capital charge, which is highest in the first depreciation runs out). With RCE, there is more incentive to replace old assets,

8 Milano, Gregory V., “Be Cautious About Sweating Your Assets,” CFO.com, Octo- while maintaining strong accountability for earning a return ber 16, 2017. over time (RCE in years six and seven is actually much lower

118 Journal of Applied Corporate Finance • Volume 31 Number 3 Summer 2019 than EVA, which by then treats capital as essentially free, with between RCE and EVA, it is easy to see that a management the asset base having been depreciated away). framework focused on improvements in RCE for the overall In addition to the predisposition to avoid replacing old business is likely to encourage a healthier balance in manage- assets, the same early negative EVA stands in the way of making ment’s focus as it makes tradeoffs between growth and return, new growth investments, such as capacity or geographic and between current and future performance. expansions. Even R&D investments work the same way, since Despite these drawbacks of EVA, there are companies that although both EVA and RCE capitalize R&D, the EVA model have been using EVA for decades, some quite successfully. The amortizes the R&D, thereby frontloading the costs in the same best example may well be a metal packaging manufacturing way it does for capital expenditures. Because the RCE model company called Ball Corporation, which began using EVA does not amortize R&D, the cost of ownership, which is just decades ago. From the end of 1999 through mid-2019, a dollar the capital charge, remains flat—as it does in the case of capital invested in Ball would be worth almost 12 times as much as expenditures—with less charge up front and no upward drift a dollar invested in the S&P 500. They have invested heavily, in performance as capitalized R&D amortizes away. both organically and through acquisitions. And since they have Acquisitions are a special kind of investment, since grown rapidly while also producing high returns on capital, the companies typically pay a premium on top of the stand-alone Ball management team shows no signs of succumbing to the enterprise value of the acquired company, which can lead to common tendency of EVA-driven companies to underinvest. not only more tangible assets, but also goodwill and other Scott Morrison, CFO, attributes Ball’s success with EVA intangibles, on the books. In the case of one client that had to the following: evaluated the performance of its businesses using the spread between return on invested capital (ROIC) and the cost of … [K]eeping EVA simple and making sure everyone under- capital—which is essentially EVA as a percentage of capital— stands it. We challenge ourselves and our whole management team we were asked to compare their acquisition analysis to an to not just drive efficiencies, but to always be looking for invest- RCE-based analysis for two deals. Where their analysis showed ments that help us grow. The status quo isn’t what we are after, we ROIC not exceeding the cost of capital until years four and are always looking for investments that will grow our EVA dollars. five for the two deals, respectively, our RCE analysis showed We are quite willing to give up some EVA in the short run, at the same deals turning positive in years one and two. And in times, in order to drive longer-term EVA improvement. the late years of the company analysis, ROIC was over 50% with the assets mostly depreciated, while RCE was close to flat The case of Ball shows that it’s entirely possible for compa- with a small upward drift. nies to embrace EVA and still invest in growth. But as the This is not to say we want management to be excited about CFO’s comments suggest, it is likely to require creating and any old acquisition that comes along; but for clearly good deals, reinforcing a culture that overcomes the natural tendencies of we’d like the measurement and incentive system to reward managers to limit investment when faced with such measures them sooner if they deliver decent cash returns. Just as in the and incentive constructs. case of organic investments, RCE provides more incentive to Moreover, when so many companies declined to pursue invest in the deal and more accountability for actually deliver- such value-creating investments, Stern Stewart responded by ing a return over time. developing a new EVA adjustment, known as the “strategic Under EVA, then, acquisitions, R&D and other growth investment adjustment.” The most common approach was to investments, and even asset replacements, all face similar short- forecast the projected EVA for a large investment, such as an term headwinds. RCE undoes these accounting effects in a acquisition. And when the early planned EVA was negative way that encourages value-creating investments—while at the (which was most of the time), the expected negative EVA was same time maintaining accountability for delivering adequate capitalized and treated as part of the investment. This provided returns over the full life of the investment. the chance to reflect positive EVA, normalize rewards, and None of this is meant to deny that the net present value encourage managers to approve such investments in a way that of EVA gives companies the right signals about value creation. EVA, without such an adjustment, would not. And since it But because the distribution of EVA by year typically shows a was the planned negative EVA that was capitalized, if the result sharp downturn when an asset is new, and the benefits appear turned out to be worse than planned, the variance would still in later years, managers in EVA-driven companies are encour- drag EVA down. (To illustrate this technique, Figure 2 shows aged to emphasize the short term. RCE, by contrast, spreads a generic version of a slide from a client presentation to inves- the benefits out more evenly over time. With these differences tors from the 1990s.)

Journal of Applied Corporate Finance • Volume 31 Number 3 Summer 2019 119 Figure 2 responds to investments and other actions, as discussed above, Strategic Investment Adjustment it is important to know that there is strong alignment with total shareholder return (TSR), which measures dividends and EVA Strategic Investment Adjustment: share price appreciation in relation to the starting share price. Capitalize Planned EVA Losses Why TSR? Why not try to explain a valuation multiple

10 instead? Investors seek to increase the value of their invest- 130 ment and it doesn’t matter if they own stocks with high or 110 low valuations; all that matters is how much the value of their 0 Forecated VA for investment grows, and it is TSR that provides the best indica- 20 an VA ilutie netment

EVA tor of this growth. In fact, our research at Fortuna Advisors 10 shows that companies with higher average valuation multiples 0 1 2 3 9 10 11 12 13 10 tend to have lower TSR.9 So, we absolutely don’t want to 20 Years maximize valuation at any given point in time—our aim is to 0 improve value over time, while also accounting for dividends 110 along the way. VA it VA ilutie netment VA it Normal netment When testing RCE’s relationship with TSR, we began by denoting the change in RCE as ∆RCE; and to allow for comparisons among large and small companies over time, we Though the strategic investment adjustment sought measured the ∆RCE over a three-year period as a percentage to smooth the EVA in the early years, and thus reduce or of the Gross Operating Assets at the start of the three-year eliminate any disincentive to invest, it added computational period. And to provide a rough control for differences in complexity that many managers found hard to process. And company characteristics and industry dynamics, we then especially for those managers that were not with the business sorted companies into 20 different industries10 to be able to when the investment was made, it was hard to accept all the calculate the industry-adjusted median TSR of companies that strategic investment capital in year seven that was not on the delivered above-median ∆RCE to those that performed below balance sheet. What could they do to improve the productivity the median level. of that capital? So, to avoid adding too much complexity, most To evaluate the key differences between RCE and EVA, companies instituted thresholds that ensured they would use we constructed an EVA-like economic profit (EP) measure this approach for only very large (strategic) investments. And based on RCE, but with depreciation and R&D amortiza- so the bias against small growth investments remained. tion charged to NOPAT, and with accumulated depreciation But worst of all, this strategic investment adjustment intro- and R&D amortization netted against capital. By isolating duced a new element of negotiation, and thus yet another these differences, this approach made sure the comparison was opportunity for the gaming of performance targets. Since the directly aimed at whether our treatment of depreciation and plan and financial forecast for the investment that was shown R&D amortization does or does not improve the relationship to the board for approval was now also used for adjusting between ∆RCE and TSR. the performance measure, management had an incentive to In each of the 20 industries, we found that separating make the early years of the forecast seem even worse than they companies based on ∆RCE provided a stronger TSR indica- expected to build a cushion into the targets. They could always tion than separating companies based on ∆EP. Consider boost the out-years projection to protect the NPV analysis to the case of Media and Entertainment, which is the indus- ensure the investment would still be approved. It’s easy to see try where ∆RCE showed the biggest advantage over ∆EP. how this gaming could be counterproductive—and so a better For each three-year cycle, we first separated companies into solution was needed.

9 Milano, Gregory V., “Is a Higher Valuation Multiple Always Better?” CFO.com, July RCE Relates Better to TSR 27, 2017. http://fortuna-advisors.com/2017/07/27/is-a-higher-valuation-multiple-always- When considering a performance measure, the primary objec- better/. 10 The study was based on the current members of the Russell 3000, excluding the tive is to ensure that the behavior being motivated when financial, insurance, and real estate industries (where RCE would need to be refined). managers seek to improve the measure is consistent with The data set is based on annual data going back to 1999 and companies were included over rolling three-year periods when there was full financial and TSR data for the full increasing the long-run value (or in finance terms, the NPV) three-year period. The data from all periods was combined to show the relationship on of the organization. In addition to testing how the measure average through all aspects of the business cycle.

120 Journal of Applied Corporate Finance • Volume 31 Number 3 Summer 2019 Figure 3 it was 1.2%, providing a difference of 36.5%. When we RCE Relates to TSR Better than EP in replicated this using ∆EP in place of ∆RCE, the high-∆EP Media and Entertainment media companies had median three-year TSR of 30.9% versus 10.9% for the low-∆EP group, for a difference of 20.0%. ∆RCE ∆EP Thus, the TSR advantage of high- versus low-∆RCE compa- Above-Median ∆RCE or ∆EP 37.7% 30.9% nies, as shown in Figure 3, was 16.5% higher than that for the Below-Median ∆RCE or ∆EP 1.2% 10.9% ∆EP companies over the three-year period, or 5.2% higher Difference 36.5% 20.0% on an annualized basis. Some companies that make significant value-creating 3-Year Cumulative TSR Advantage 16.5% investments in the future will see their EP decline in the near Annualized TSR Advantage 5.2% term for reasons discussed earlier, moving them into the below-median ∆EP group. But if investors have confidence in those investments, their TSR is likely to remain high. And to those above and below median on ∆RCE as a percentage of the extent the market “looks past” the low EVA, the difference beginning Gross Operating Assets. Then we aggregated all between the median TSRs of the high- and low-∆EP groups the companies from all three-year cycles and measured the tends to be smaller than in the case of the ∆RCE groups, median TSR for each group. reducing the explanatory power of EP relative to RCE. As The median three-year TSR for the high-∆RCE media shown in Figure 4, this RCE advantage can be seen in all of companies was 37.7%; for those with below-median ∆RCE, the industries we looked at.

Figure 4 Annualized TSR Advantage of RCE vs. EP

Annualized TSR Advantage RCE vs. EP Median TSR of Above Median ∆RCE or ∆EP Companies vs. Those Below Median

edia and ntertainment 5.2%

Conumer urable and Apparel 3.2%

aterial 2.7%

ealt Care uipment and Serice 2.5%

Food and Staple etailin 1.9%

armaceutical iotecnolo and ife Science 1.9%

elecommunication Serice 1.8%

Softare and Serice 1.8%

Capital ood 1.7%

etailin 1.7%

ranportation 1.1%

oueold and eronal roduct 1.0%

ner 1.0%

tilitie 1.0%

Automobile and Component 0.8%

Semiconductor and Semiconductor uipment 0.8%

Commercial and rofeional Serice 0.6%

ecnolo ardare and uipment 0.5%

Food eerae and obacco 0.3%

Conumer Serice 0.2%

Journal of Applied Corporate Finance • Volume 31 Number 3 Summer 2019 121 Figure 5 Amazon’s RCe-Implied Share Price vs. EVA-Implied Share Price

EVA-Implied Share Price: Amazon.com, Inc. RCE-Implied Share Price: Amazon.com, Inc. 2000 2000

100 100

2ee i 2ee i 100 100 ail Aerae Cloin rice ail Aerae Cloin rice 100 2ee lo 100 2ee lo

1200 1200

1000 1000

00 00

00 00

00 00

200 200

0 0 2009 2010 2011 2012 2013 201 201 201 201 201 2009 2010 2011 2012 2013 201 201 201 201 201 neted Capital e Net ebt per Sare Capitalied VA per Sare ro peratin Aet e Net ebt per Sare Capitalied C per Sare

These findings suggest that RCE is a more reliable proxy 2018 by assuming that its current performance continues for value creation than EP (or EVA), and that one should feel forever, thus providing investors with what amounts to a confident that if management devotes its efforts to growing perpetuity of its most recent year’s results. In the EVA litera- RCE, high TSR should follow. ture, this calculation is referred to as a company’s “current operations value” (or COV). Any difference between a RCE Spotlight: Stop Seeing Amazon as Unprofitable company’s current enterprise value and its COV is known as In the modern world, where growth in many industries is its “future growth value” (or FGV). FGV, at least in theory, increasingly driven by investment in intangibles and R&D also represents the NPV of expected increases in EVA. (as opposed to tangible, fixed assets), RCE is designed to The findings of our analysis are shown in Figure 5, which reflect value creation in this environment. As a testament to shows Amazon’s 52-week high, low, and average daily closing this possibility, in 2017 the Fortuna team and I published prices for each of the ten years. In the graph on the left side an article in the Journal of Applied Corporate Finance on the of the figure, the lower stacked bar reflects the book value valuation of high-tech companies that showed how RCE of the capital invested in Amazon, reduced by net debt, on could be used to explain, among other things, the remark- a per share basis. The upper bar reflects the per share value able valuation of Amazon, then about $1,200 a share.11 Here of Amazon’s EVA divided by the weighted average cost of we have taken this analysis a step further to show how well capital, which is the present value of flat EVA in perpetuity. RCE explains the 50% increase in Amazon’s share price The right graph is similar, except the lower bar reflects the since then. per share value of Gross Operating Assets less net debt and Using first EVA (based on the EP methodology the upper bar reflects capitalized perpetual RCE per share. discussed above) and then RCE, we estimated the value of During the 2009-2012 period, both valuations seem Amazon shares over the entire ten-year period ending in low, with meaningful growth assumptions—and hence large FGVs—baked into the share price.12 But from 2013 through

11 Milano, Gregory V., Arshia Chatterjee, and David Fedigan, “Drivers of Shareholder Returns in Tech Industries (or How to Make Sense of Amazon’s Market Value),” Journal 12 From 2009 through 2012, the EVA-implied value represented an average dis- of Applied Corporate Finance 28, no. 3 (2016): 48-55. count of 58% and the same statistic was 32% for RCE, so even during this period, the

122 Journal of Applied Corporate Finance • Volume 31 Number 3 Summer 2019 2018, the measures give very different valuation impressions. clear that some of these processes were subtly, and inadver- On average, the RCE-implied valuation during this period tently, reducing management’s motivation to invest in critical is within 1% of the actual daily average closing price, while R&D and innovation. the EVA-implied share price sits at a 58% average discount. As the centerpiece of a new way of thinking and running Amazon has been heavily investing in building an airline and a the business, Varian’s management decided in 2017 to adopt network of warehouses with trucks and other equipment; and a customized measure known internally as “VVA,” or Varian the huge depreciation associated with this investment, along Value Added, which is a customized version of RCE. One of with the amortization of capitalized R&D, has constrained the the most important benefits of VVA over traditional economic growth in EVA, but not RCE. From 2012-2018, our estimates profit is that it treats expenditures in R&D as investments show that Amazon’s RCE increased by over $38 billion while rather than period expenses, as in standard GAAP procedures. EVA improved by less than $11 billion (see the Appendix for As Gary Bischoping, Varian’s CFO, said about the compa- the calculations). ny’s new performance evaluation framework, This is an interesting case study that demonstrates the explanatory power of RCE versus EVA in new economy This removes any incentive to cut R&D to meet a short-term companies, and the implications are huge. There are many goal, so it promotes investing in innovation. At the same time, large traditional retailers that have attempted to compete since there is enduring accountability for delivering an adequate with Amazon but few have succeeded in any meaningful way. return on R&D investments for eight years, there is more incentive This illustration raises the possibility that traditional finan- to reallocate R&D spending away from projects that are failing cial metrics have discouraged Amazon-like investments and and toward those that project the most promising outcomes—for strategies. If Walmart, Home Depot, Best Buy, Macy’s, and patients and shareholders. others had been using RCE to develop business plans, evaluate investments, and measure performance for bonuses, would In parallel with the launch of new incentive designs, the Amazon now have more successful competitors? company embarked on several layers of communication and training. RCE Case Study: Varian Medical Systems In the next step, Fortuna and Varian collaborated to For over 70 years, Varian Medical Systems has helped lead understand the investor expectations that were baked into the fight against cancer by innovating cancer therapies, and the share price and to estimate the amount of VVA improve- the company is currently the market leader in radiation ther- ment required to expect to deliver a top-quartile TSR among apy.13 The number one priority of Varian management is to peers. This estimate in turn provided a basis for estimating find new and better ways to increase access to cancer care for how much investment was needed over time. Since one of more patients across the globe. the most common causes of growth shortfalls is underinvest- Historically, Varian’s competitive advantage has derived ment, this goal-setting process was designed to determine at from a culture of innovation premised on and supported by the outset how much investment would be required to achieve significant R&D investment. But after a long run of innova- the company’s goals. This exercise led management to think of tion that both extended Varian’s therapeutic reach and resulted investments in a different and more productive way. in strong growth through the mid-2010s, the company’s TSR Planning has evolved at Varian as well, and is now began to sag. On closer inspection, the main reason for the designed to balance short- and long-term goals using paral- stagnating share price was a slowdown in the company’s release lel “run-the-business” and “change-the-business” frameworks of new, innovative products to drive the market—and this that allocate resources to the most productive users and uses meant that the company’s capacity to reach patients was being of capital. Whether growing current business lines or funding undermined. innovation for future products and services, the process seeks As management dug deeper into the company’s invest- to find the best value-creation opportunities and dedicate ment decision-making and compensation processes, it became more resources to these areas. The planning and budgeting processes have benefited from how VVA integrates the P&L differences in value were large. with the balance sheet, and from the reinforcement of incen- 13 This case study is based on the article “How One Company Balanced Current Performance with Investing in the Future,” published by FEI Daily. tives that are no longer tied to budgeted goals. Milano, Gregory V. and Gary E. Bischoping, Jr., “How One Company Balanced Current Every major investment, including capital expenditures, Performance with Investing in the Future,” FEI Daily. June 26, 2019. https://fortuna- advisors.com/2019/06/26/how-one-company-balanced-current-performance-with-in- R&D, and potential acquisitions, is now evaluated using VVA. vesting-in-the-future/. Although the NPV of VVA is similar to NPV based on free

Journal of Applied Corporate Finance • Volume 31 Number 3 Summer 2019 123 cash flow, the benefit comes from the way the methodology for so many years, and equally grateful for the opportunity to ties directly to how management will be measured after the participate in this memorial to his life’s work. investment. The company evaluates NPV as a percentage of EVA was a game changer in the field of performance the investment, which is referred to as the “VVA profitability measurement—no question about it. It was the first measure index” and can be compared to “margin of safety” hurdles. to successfully combine aspects of both quantity (think This approach provides a more reliable way to prioritize invest- EBITDA) and quality (return on capital) into one compre- ment opportunities than using internal rate of return (IRR), hensive, reliable measure of value creation. Yet for all of its which has a number of problems.14 benefits, EVA’s success was limited by its drawbacks: too much This case study shows how a customized version of complexity, along with the pressure to underinvest exerted by economic profit, derived from RCE, can be used to drive its frontloading of investment costs. planning and motivate better investment decision-making. We at Fortuna Advisors are proud to carry the torch in In the case of Varian, VVA helped clarify which businesses, pursuit of better performance measurement and more value markets, and acquisitions could create the most value, and creation—not just for shareholders, but for all stakeholders even led the company to shift capital from its buyback and society at large. None of this would have been possible program to more promising long-term investments. without Joel’s contributions to this effort. Thank you, Joel.

Conclusion GREG MILANO is the Founder and Chief Executive Officer of Fortuna As many readers will be aware, this issue of the Journal of Advisors, an innovative strategy consulting firm that helps clients deliver Applied Corporate Finance follows the recent passing of Joel superior Total Shareholder Returns (TSR) through better strategic resource Stern, co-founder (with Bennett Stewart) of Stern Stewart and allocation and by creating an ownership culture. He is the author of the co-inventor of EVA. In this sense, this issue is a tribute to, and forthcoming book, Curing Corporate Short-Termism. Previously, Greg was celebration of, Joel’s life and his enduring contributions to the a [artner of Stern Stewart, where he founded Stern Stewart Europe and study and practice of corporate finance. I am deeply grateful then became president of Stern Stewart North America. for the opportunity to have worked with and learned from Joel

14 The typical approach to prioritizing investments is to use the internal rate of re- turn, or IRR; but four major flaws affect this approach. The first is that if a project has cash flows that flip direction more than once, there will be multiple IRR solutions. Which one do you use? The second flaw is that projects with different durations can have the same IRR and yet very different net present values, which can lead to poor prioritizations and underperformance. Third, IRR also assumes that cash inflows are reinvested at the IRR, while NPV doesn’t. Finally, IRR doesn’t indicate the dollars of value creation, where- as NPV does. This is important when thinking about prioritization under constraints, such as a limited number of managers or a fixed capital budget, because only NPV can be used to find value optimization.

124 Journal of Applied Corporate Finance • Volume 31 Number 3 Summer 2019 Appendix: RCE vs. EVA Calculations for Amazon Figure 7 It is perhaps easiest to understand the differences between 2018 NOPAT and Gross Cash Earnings for Amazon.com RCE and EVA by viewing the calculations, so the following explains the 2018 RCE and EVA calculations for Amazon. 2018 EVA (EP) RCE com. As in the body of the article, the simplified Economic Revenue $232,887 $232,887 Profit (EP) calculation is used as a proxy for EVA. Cost of Goods Sold and Other Operating The first step is to calculate Capital and Gross Operating Expenses (incl R&D) (220,466) (220,466) Assets, shown in Figure 6. Whereas invested capital, as used in Operating Profit 12,421 12,421 Depreciation and Amortization Add-Back 15,341 the calculation of EVA, includes PP&E net of depreciation and Rental Expense Add-Back 3,400 net capitalized R&D, with the cumulative R&D amortization Rental Implied Interest Add-Back 1,082 R&D Amortization (17,871) subtracted, the Gross Operating Assets used when calculating R&D Expense Add-Back (Technology & Content) 28,837 28,837

RCE is based on gross PP&E and Gross Capitalized R&D. Adjusted Operating Profit Before Taxes 24,469 59,999 Note that both measures include capitalized leases based on the Taxes (Kept the same for simplicity) (1,988) (1,988) present value of the reported minimum lease commitments. Net Operating Profit After Taxes (NOPAT) 22,480 Figure 6 Gross Cash Earnings (GCE) 58,011 2018 Invested Capital and Gross Operating Assets for Finally, we estimate the implied share prices by subtract- Amazon.com ing net debt from capital and Gross Operating Assets, on a

2018 EVA (EP) RCE per share basis. We then determine a premium above this by Net Working Capital (Operating) ($25,456) ($25,456) capitalizing the EVA and RCE on a per share basis, and this Gross PP&E 95,770 95,770 is where the real value shows up for Amazon.com. The EVA Accumulated Depreciation (33,973) (EP)-implied share price only reflects one-third of Amazon’s Net PP&E 61,797 share price, indicating an enormous future growth value Gross Capitalized R&D 89,357 89,357 Cumulative R&D Amortization (36,083) (FGV), especially for a company that already has $233 billion Net Capitalized R&D 53,274 in revenue—how big are they expected to get? RCE implies a Capitalized Operating Leases 19,603 19,603 more modest FGV of 11% of the valuation. Other Net Operating Assets 14,389 14,389 Invested Capital 123,607 Figure 8 Gross Operating Assets (GOA) 193,663 2018 EVA (EP) and RCE, and Implied Share Prices for Amazon.com The second step is to calculate the two measures of income: Net Operating Profit after Taxes (NOPAT) for the 2018 EVA (EP) RCE EVA calculation, and Gross Cash Earnings for RCE, which is Net Operating Profit After Taxes (NOPAT) $22,480 shown in Figure 7. One of the two major differences between Gross Cash Earnings (GCE) 58,011 Average Capital 109,652 the two measures is that depreciation and R&D amortization Weighted Average Cost of Capital 8.7% are charged to NOPAT, while neither is charged to Gross Capital Charge (9,587) Cash Earnings. The other difference relates to the treatment of Average Gross Operating Assets 168,674 leases, with EVA adding back the implied interest based on the Required Return 8.3% Capital Charge (13,973) amount capitalized, while RCE has the full rent added back EVA (EP) 12,894 to be consistent with excluding all depreciation. RCE 44,038

We combine these findings to determine EVA (EP) and Shares Outstanding 491.0 491.0 RCE, and we then use these estimates of EVA and RCE to Net Debt 8,039 8,039 determine the implied share price based on a perpetuity valua- Average Daily Closing Share Price $1,641.73 $1,641.73 tion. As shown in Figure 8, we determine the capital charge [Capital-Net Debt] per share $235.37 EVA/WACC per share (reflects PV of a perpetuity) $300.36 in each case by multiplying the average of the beginning and EVA Implied Share Price (COV) $535.73 ending balance of capital or Gross Operating Assets by the Premium (Discount) -67.4% WACC or Required Return, and this is subtracted from the [GOA-Net Debt] per share $378.05 RCE.Req’d Return per share (reflects PV of a NOPAT or Gross Cash Earnings. As can be seen, the amount perpetuity) $1,082.69 of RCE is over three times that of EVA, and this difference is RCE Implied Share Price $1,460.74 large because Amazon has generally new assets and the differ- Premium (Discount) -11.0% ences are quite material.

Journal of Applied Corporate Finance • Volume 31 Number 3 Summer 2019 125 Are Performance Shares Shareholder Friendly? by Marc Hodak, Farient Advisors

ince the early 2000s, executive compensation has experienced a secular shift S toward performance shares1—equity awards whose vesting is based on perfor- mance as opposed to time or service. In the past, for example, an executive might have been granted mostly restricted stock units (RSUs) that would vest over a three-year period; they simply had to stick around to get all the shares. Today, an executive is more likely to be granted over half their awards in performance share units (PSUs) that vest at the end of three years; in such cases, the number of shares that actually vest can be more or less than the nominal grant, depending on how well the company performs during that period. Ten years ago, less than half of S&P 500 firms awarded PSUs. Today, as shown in Figure 1, over 80% of them do, and PSUs have become an increasingly larger percentage of the long-term incentive (LTI) mix within those companies.

Figure 1 Prevalence of PSUs in LTI Plans in the S&P 500

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1 Shares with performance-based vesting are generally awarded as “performance share units,” or PSUs. This article uses “performance shares,” “performance share units,” and “PSUs” interchangeably.

126 Journal of Applied Corporate Finance • Volume 31 Number 3 Summer 2019 This growth in PSUs has been driven largely by the efforts of scale of the portion of granted shares that vest across various influential institutional investors and their proxy advisors to performance levels, from threshold to target to maximum. promote what they believe to be a more shareholder-friendly These plans must be calibrated to yield rewards that make award than restricted stock or stock options, which these sense across the entire spectrum of possible performance investors have taken to calling “non-performance based.” outcomes. Further complicating matters, PSUs increas- However, investors are by no means in complete agreement ingly include additional “triggers” or “governors” designed to about how pay for performance should be implemented in prevent unintended windfalls due to the uncertain relation- companies. Fissures have begun to appear in the general senti- ship between accounting-based metrics, such as earnings or ment about performance shares. returns, and stock price over multiple years. Such complex- Perhaps most notable, in 2017 the well-known Nordic ity makes these plans much less transparent to even the plan sovereign wealth fund, Norges Bank, came out with a widely participants, some of whom have dismissed them as “black circulated white paper that declared a preference for share box” reward mechanisms, thus casting considerable doubt on awards without performance conditions, arguing that the use their actual incentive effect. of complex performance criteria does not necessarily enhance alignment between corporate managements and their share- holders. Other investors have recoiled at the increase in the sheer volume of pay disclosures, which have been largely “ driven by descriptions of performance share plans. In fact, Whether their end-of-year goals were set one year PSUs have evolved to the point of presenting significant struc- tural and economic problems that should cause more investors ago or three years ago is immaterial to the short-term to rethink them. behavior that the plan can drive. Performance Shares Significantly ” Complicate LTI Plans Time-based grants of restricted stock or stock options are easy; if the executive sticks around, the shares or options eventually This complexity has also, not surprisingly, proved frustrat- vest. Notwithstanding their “non-performance” label, these ing for investors trying to evaluate the plans. Working against types of equity awards can effectively align the interests of investors’ desire for “shareholder-friendly” incentive compen- managers and shareholders by directly, transparently tying the sation plans, PSUs, with their exotic features in overlapping personal net worth of the executives to the ups and downs of grant and performance periods, are often the most compli- the stock price. cated parts of today’s compensation disclosures. And since the How effective is that alignment from the shareholder’s inner workings of these plans are often poorly understood by perspective? Empirical studies have shown, with remark- internal as well as external stakeholders, it is almost impossible able consistency, a significant positive relationship between to explain counterintuitive pay results, even when such results management ownership of shares and the enhancement of were intended by the designers of the plan. shareholder value. Indeed, this is one of the most robust results in the peer-reviewed, corporate governance literature—one Performance Shares Turn Out to Be More Costly, Too that has been replicated over several decades of scholarship In a recent study, my Farient colleagues and I looked at LTI covering many different nations and regulatory regimes.2 awards across S&P 500 firms containing significant PSUs Compared to straight equity grants, performance shares versus those containing only RSUs or stock options for each introduce significant complexity into long-term incentives. To year over the ten-year period from 2008 to 2017. During this determine how many of the granted shares will vest, the plans period, CEOs who received a significant portion of their LTI must include performance measures and, for each measure, a awards in the form of PSUs were awarded median grant values that were roughly 35% higher than those for CEOs who 2 McConnell, John J., and Henri Servaes, “Additional evidence on equity ownership received only restricted stock or stock options. Moreover, as and corporate value,” Journal of Financial Economics, 27 (1990) pp. 595-612; de Miguel, Alberto, Julio Pindado, Chabela de la Torre, “Ownership structure and firm value: can be seen in Figure 2, in nine out of eleven sectors, the grant new evidence from Spain,” Strategic Management Journal, Volume 25, Issue 2 date value of LTI awards that included PSUs was materially (December 2004) pp. 1199-1207; Von Lilienfeld-Toal, Ulf and Stefan Ruenzi, “CEO Ownership, Stock Market Performance and Managerial Discretion,” The Journal of Fi- higher than for those getting only RSUs and stock options. nance, Volume 69, Issue 3 (June 2014), pp. 1013-1050. In the case of the average company switching from “non-

Journal of Applied Corporate Finance • Volume 31 Number 3 Summer 2019 127 Figure 2 Median of Grant-Date Values of Equity in S&P 500 Firms from 2008-2017

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0 Communication Conumer Conumer ner Financial ealt ndutrial nformation aterial eal tilitie Serice icretionar Staple Care ecnolo tate performance” equity awards to PSUs over the last decade, the are, contributing to this effect—but the basic risk-reward median CEO received an approximately 40% increase in the imperative that comes with PSUs is also almost certainly a grant date value of their award. contributor. The most likely explanation for this increase in grant date values should make perfect sense to any investor—namely, Performance Shares Hurt Corporate Performance that performance shares create greater compensation risk than Even if performance shares cost more, they may be worth it if an equivalent value of time-based equity, especially RSUs, and they lead to better company performance. Given the proven no one should be expected to accept greater risk without the benefits of management share ownership, it seems plausible prospect of a greater reward. Furthermore, our firm’s experi- that alignment may be improved by layering on performance ence in developing offers for senior executives suggests that conditions before allowing stock to vest. Not only would they almost invariably view RSUs as more valuable than an management have their personal wealth tied to the stock price equivalent, nominal value of PSUs, especially in periods of by virtue of the change in value of whatever shares they end volatility. PSUs can also feel riskier than options to manag- up with, but they would also have to have performed well to ers in a period of rising stock prices, as historically granted obtain those shares. This hypothesis is enhanced by the fact options increasingly find themselves “in the money.” Tellingly, that managers see a more direct connection between their over the last ten years, relatively higher-risk sectors such as actions and the measures that often drive performance awards, Financials, Health Care, and Consumer Discretionary saw such as earnings or revenue, than between their actions and the largest cost differences in grant values for “performance” the company’s stock price. vs. “non-performance” share awards, while lower-risk sectors Unfortunately, this theory runs up against another such as Utilities, Consumer Staples, and Real Estate have had powerful strand of research into incentives: it is exceedingly the most comparable grant values. difficult to find any relationship between the bonus rewards In light of these findings, it seems ironic that many received by managers and value created for their sharehold- investors have supported the use of performance shares with ers. A number of reasons have been offered for why bonus the expectation that the growing use of PSUs would have plan outcomes correlate so poorly with shareholder value. A the ultimate effect oflimiting , not increasing, overall CEO leading contender is that rewards based on a set of concrete pay. Instead, CEO pay has stubbornly grown alongside the metrics and goals to be achieved in a limited time intro- increasing prevalence of performance shares, despite the duce “short-termism” in management behavior. Knowing greater scrutiny to which their pay has been subjected. Of that the clock will strike midnight at the end of a plan year course, many factors other than PSUs could be, and likely clearly focuses management on the particular metrics and

128 Journal of Applied Corporate Finance • Volume 31 Number 3 Summer 2019 goals being rewarded in that period. But, such focus also can also provide that exposure, but with a significant dose of encourages less attention to potentially important things uncertainty about ownership. For example, if management is that are not being measured, or will not show up until after considering a major strategic investment just as a performance the plan year is over. period is coming to an end, do we really want management The existence and effects of “short-termism” have been to be weighing a near-certain 5% or 10% hit to the number documented in numerous studies. One much-cited Duke of shares they may end up with due to the projected, negative University survey of some 400 public company CFOs effect of the investment on their PSU metrics against the conducted in 2005 and repeated in 2013 included the expected, but eventual 2% or 3% gain in total shareholder question: Would you be willing to sacrifice economic value returns (TSR) from going through with the investment? in order to hit an earnings target? Over three-fourths of the So, the question arises: Which incentive effect dominates? responding CFOs admitted that their companies would Do the alignment benefits created by stock ownership, albeit consider doing that. That, in a nutshell, is the inherent hazard at an uncertain level, outweigh the potential “short-termism” of short-term plans.3 associated with the temporal bonus mechanism that deter- Since performance share plans are typically “long-term” mines the number of shares that one ends up with? plans, we might suppose that these effects would be much less In a recent study, we looked at relative total shareholder relevant. However, managers don’t distinguish short- from returns (RTSR) during three-year periods over the last ten long-term plans based on how far into the future performance years for S&P 500 companies that awarded performance will be measured; they distinguish them based on the vintage shares versus those that awarded solely “non-performance” of the goals for the coming year-end. Whether their end-of- equity. Notwithstanding the mix of stated preferences among year goals were set one year ago or three years ago is immaterial investors, their market behavior spoke clearly. As shown in to the short-term behavior that the plan can drive. Figure 3, companies with PSU plans underperformed their This reality of managerial behavior brings up potentially sector peers, while companies making straight grants of important problems associated with short-term plans, while restricted stock or options outperformed their sector peers in magnifying their likely effects: every three-year period we looked at. The first is that long-term goals based on accounting What’s more, the underperformance of PSU-laden plans results, such as earnings or return on capital, are likely to and the outperformance of “non-performance” plans across become stale as managers get nearer the end of the plan. More this period were both statistically significant. In other words, so than in annual plans, three-year plan targets are likely to “performance shares” don’t appear to perform for shareholders. be long-since achieved, or no longer achievable, well before the end of the performance period. Furthermore, any interim What Investors Want shift in the strategic landscape, which is highly likely within These findings challenge us to reinterpret “what investors any three-year period, could make such goals no longer worth want” since investor preferences have been the main driver of achieving. This would require the company either to renegoti- the shift towards performance shares. ate the goals, undermining the integrity of the plan, or to risk There continues to be a broad consensus in support of the rewards or penalties associated with meeting the goals of the basic idea of pay-for-performance for top executives. a plan that no longer drives shareholder value. Boards and the executives themselves, as well as investors, By contrast, share ownership is by its nature long-term generally agree with that principle. But how pay-for-perfor- and value-focused, and has no expiration date. And ownership mance manifests in incentive plans is open to a wide range without the added contingencies introduced by PSUs gives of possibilities. Performance shares are one manifestation, management the widest strategic range in pursuing opportuni- and may well be the best choice for long-term incentives for ties as they arise. If managers have the opportunity to sacrifice certain companies—for example, those where performance some short-term earnings or returns in favor of significantly metrics reliably capture changes in long-run corporate higher future earnings or returns, they will make the trade- values. But the idea that companies should uniformly be off in favor of maximum value creation, consistent with the implementing performance shares as their dominant LTI positive impact on their personal wealth. Performance shares vehicle is likely to be counterproductive to the interests of those promoting them. Unfortunately, knowing that PSUs may increase compen- 3 Graham, John, Campbell Harvey, and Shiva Rajgopal, (2005), “The economic implications of corporate financial reporting,”The Journal of Accounting and Economics sation cost and hurt performance does not absolve companies 40 (1-3):3-73. from having to reckon with “what investors want,” especially

Journal of Applied Corporate Finance • Volume 31 Number 3 Summer 2019 129 Figure 3 Three-Year TSR Relative to Sector Peers for S&P 500 Firms

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Note: Companies “With PSUs” awarded at least 20% of their long-term incentives in performance shares. “No PSUs” firms awarded only restricted stock or stock options (or a combination) without performance conditions. as distilled by their proxy advisors. As long as ISS and Glass- affecting corporate performance, it may be time for more Lewis continue indiscriminately to endorse and push all investors to join the growing backlash in their ranks against companies to make the majority of their LTI awards “perfor- PSUs, and to begin communicating a more nuanced view and mance-based,” boards will continue to implement PSUs on expectation of their adoption by companies in their portfolios. an ever-growing scale. It may also be time for proxy advisors to look at the evidence Boards can, and some do, push back against “best on PSUs and shareholder value in shaping their standards, and practices” that don’t line up with their sense of what is best adjust their advice accordingly. for their companies. But given the business model of proxy advisors and the influence they wield over public companies, Marc Hodak is a Partner at Farient Advisors, an independent exec- the trend towards performance shares is unlikely to be arrested utive compensation and performance consultancy. Also contributing to without pressure from more large investors re-evaluating what this article was Eric Hoffmann, Vice President and Leader, Farient Infor- is truly shareholder friendly when it comes to LTI plans. In mation Services. light of the evidence of how performance shares are actually

130 Journal of Applied Corporate Finance • Volume 31 Number 3 Summer 2019 Why EVA Bonus Plans Failed— and How to Revive Them by Stephen O’Byrne, Shareholder Value Advisors

ost top executives and operating heads run their companies or businesses, M set their goals, and reward their employees using earnings-based measures of performance. But the focus on earnings has two critical weaknesses that can undermine the alignment of earnings-based pay with shareholder wealth. First, it’s often easy to boost current earnings by “underinvesting”—that is, by making shortsighted cuts in advertising or R&D that end up reducing future earnings. But less obvious is the reality that growth in earnings per share can also be achieved by “overinvesting”—pouring additional capital into projects with expected rates of return that, although well below the cost of capital, are higher than the after-tax cost of debt.

Stock compensation has been the conventional solution to the EVA-like bonus formulas (with charges for total capital) in first, or “underinvestment,” problem because stock prices are the first half of the 20th century, but all of them eventually supposed to reflect discounted cash flow values; and significant dropped fixed sharing of such EVA and adopted pay programs stock holdings, to the extent they reward promising long-run based on “competitive pay” concepts.1 Stern Stewart & Co. investment, should discourage management from actions that was successful in creating a second wave of EVA use in the sacrifice future earnings. Economic profit, or “EVA” in its 1990s, but a 2009 study by David Young and me found that best-known version, was once the most common answer to the only six out of some 66 Stern Stewart clients using EVA in “overinvestment” problem associated with earnings because 1999 were still using it in 2008.2 EVA charged operating managers for the use of equity as well EVA is ideally suited to and has tended to be used in as debt capital. And because it includes such a capital charge, multi-year comp plans that promise managers a fixed share of EVA, unlike GAAP earnings and most widely used perfor- their business’s EVA, increase in EVA, or some combination mance measures, can be linked directly to the discounted cash of the two.3 As a result, any perceived deficiencies in how flow value that gets reflected in stock prices. EVA is measured or used to set performance targets make But neither of these conventional solutions appears to it difficult for directors (or investors) to insist on the use of have worked very well in practice, at least not for operat- ing heads. Stock compensation, besides failing to reflect the 1 For more detail on this transition, see O’Byrne, Stephen F. and E. Mark Gressle, performance and value of specific business units, often fails “How Competitive Pay Undermines Pay for Performance (and How to Change That),” Journal of Applied Corporate Finance, Vol. 25 No. 2 (Spring 2013) and O’Byrne, Ste- to provide the intended incentives for the (many) corporate phen F. and S. David Young, “The Evolution of Executive Pay Policy at General Motors managers who believe that meeting or beating current consen- 1918-2008,” Journal of Applied Corporate Finance, Vol. 29 No. 1 (Winter 2017). 2 O’Byrne, Stephen F. and S. David Young,”Why Capital Efficiency Measures Are sus earnings is more important than investing to maintain Rarely Used In Incentive Plans, and How to Change That,” Journal of Applied Corporate future earnings. EVA bonus plans have been tried by many Finance, Vol. 21 No. 2 (Spring 2009). 3 Fixed sharing plans are more demanding than competitive pay plans because, companies, but the vast majority of these plans have been unlike the latter plans, they don’t increase sharing to “make up for” the impact of poor abandoned. Many if not most public companies adopted performance.

Journal of Applied Corporate Finance • Volume 31 Number 3 Summer 2019 131 these more demanding pay practices instead of falling back incentive plan that gave its senior management team 10% of on conventional bonus plans that commonly treat inves- the company’s dollar profits above a capital charge equal to tor capital as “free.” My aim in these pages is to describe 7% of net assets.5 improvements in both the measurement of EVA and its use The program was remarkably durable—undoubtedly in designing targets that have the potential to contribute the world’s longest-lived EVA bonus plan—lasting from to a revival of the modern EVA bonus plan, one with the 1918 to 1982. Similar plans were adopted by many public promise of providing not only a much stronger alignment companies during this period, though few lasted beyond of pay and performance than conventional plans, but a way the 1960s, mainly because of the rise of “competitive pay of overcoming the charge of short-termism that is now so practices” that rewarded companies for growth (in EPS as often directed at EVA plans. well as sales) rather than profitability.6 In this article, I will start by showing that the one largely When I joined Stern Stewart & Co. to run its incentive unrecognized fundamental challenge in EVA performance comp practice in the early 1990s, most of the EVA plans still measurement is that the increases in current EVA that are in existence had evolved into plans that gave management rewarded by such plans are more often than not associated a share of not only EVA, but also the increase in EVA— with declining expectations for future EVA increases (or what with the latter aimed at providing stronger incentives for I’ll later call declining “future growth values”). The EVA low-profit, but improving businesses. But this structure bonus plans of the 1990s were typically designed to reward made it difficult to achieve a key objective of compensa- increases in EVA over and above the expectations for such tion plans: providing “market” compensation for executives “EVA improvement” that were reflected in their stock prices when, and only when, there was enough EVA improvement at the start of the plans. But because such plans made no to ensure that investors would earn a cost-of-capital return effort to capture any changes in investor expectations from on the company’s market value at the start of the plan. that point onward, managers were often effectively rewarded In response to this challenge, we developed the “modern for EVA improvements that may well have been achieved at EVA bonus plan” that made the bonus earned equal to a the expense of future growth opportunities. In other words, the target bonus plus a fixed share of what we called “excess EVA EVA increases being rewarded by such plans may have resulted improvement.” Our analysis shows that a company’s current from margin improvements at the expense of growth or from stock price implies a certain level of expected increase in its managers’ decisions to pass up positive-NPV growth projects current EVA; and a company’s excess EVA improvement was that would have reduced their current EVA.4 the difference between the actual increase in EVA during the As one potential solution to this problem, I close by performance period and the “expected EVA improvement,” suggesting the possibility of developing current operating or “EI.” Our estimate of EI was the annual increase in EVA measures—based on factors such as revenue growth, dollar that, given the company’s stock price at the start of the plan, profit margin from capital growth, and increases in R&D and was required to provide investors with a rate of return on capital spending—that provide reasonably reliable proxies for market value equal to the company’s cost of capital future EVA improvement. Such proxy measures could provide And since excess EVA improvement could—and often the basis for “dynamic” EVA improvement targets that are did—turn out to be negative, the managers’ share of excess raised when managers increase EVA by increasing margins EVA improvement, and the total bonus earned, could also (instead of growth) and are adjusted downward when manag- be negative. Negative bonuses were recorded as entries in ers make growth investments that typically reduce current a “negative bonus bank” that had to be recouped before EVA, with the aim of counteracting and even eliminating the additional bonus was paid. The target bonus was set so EVA bias toward “short-termism.” as to provide a market level of total compensation. The point of this design was to ensure that executives would A Brief History of EVA Bonus Plans earn competitive compensation in the labor market when The earliest EVA bonus plans gave managers a fixed share of and only when investors earned competitive returns in the their operation’s EVA. In 1918, General Motors adopted an capital market.

4 EVA improvement from underlying business growth normally has a more positive effect on future growth value than EVA improvement from margin improvements (e.g., price increases and cost cuts). When managers shift EVA improvement from business growth to margin improvement, expectations of future EVA improvement typically de- 5 The minimum return was 6% from 1918 to 1922 and 7% from 1922 to 1947. cline. 6 See O’Byrne and Young (2009) above.

132 Journal of Applied Corporate Finance • Volume 31 Number 3 Summer 2019 Figure 1 Figure 2 Capitalized EVA and FGV for Apple Capitalized EVA and FGV for Amazon

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Future Growth Value Often Falls When economy has caused FGVs to account for ever larger fractions Current EVA Goes Up of corporate enterprise values, at least on average, during the To understand why current EVA improvement is frequently past two or three decades. associated with declines in expected future EVA improvement, let’s take a look at the “EVA math.”7 The first component An Aside on MVA as the Corporate Goal of the EVA math says that a company’s current enterprise But that said, Stern Stewart has long advocated an alternative value—the market value of its equity plus its debt—can be way of viewing a company’s market enterprise value—namely, broken down into three components: (1) book capital (which as the sum of its book capital and its “Market Value Added” can also be viewed as a rough proxy for the amount of capital (or “MVA”). When viewed as part of the EVA math, MVA that (debt and equity) investors have put into a company); (2) is the sum of the second and third components of market the capitalized (or perpetuity) value of its current EVA (assum- enterprise value—capitalized current EVA and FGV. And as ing it remains at that level forever); and (3) what we refer to its name suggests, Market Value Added has long been cited by as its “future growth value,” or “FGV.” Stern Stewart as both the most definitive measure of investors’ A company’s FGV can be calculated in two different ways. wealth gain—that is, the value of their ownership in excess First, and most straightforward, since FGV is the part of a of the cost of their investment—and, as such, the most reli- company’s market enterprise value that cannot be explained by able measure of management’s cumulative, long-run success. its current capital and EVA, it can be calculated just by subtract- But as I show in the Appendix, MVA is a potentially ing the first two components—book capital plus the capitalized highly misleading proxy for what really matters to investors— value of current EVA (EVA/WACC)—from its current market what I call their “dollar excess return.” And more important enterprise value. The alternative is to view—and attempt to for purposes of this article, a focus on MVA obscures the quantify—a company’s FGV as the discounted present value negative correlation of the two components of MVA—current of expected future increases in EVA. The sum of the first two EVA performance and future growth value—which I show components of market value—book capital plus capitalized below has proved to be a critical problem in EVA performance current EVA—is what we call a company’s “current operations evaluation. value,” or “COV.” And so a company’s market enterprise value To see where the problem originates, Figures 1 and 2 show can also be thought of as the sum of its current operations value the relationship between the two components of MVA—the (COV) and its future growth value (FGV). capitalized value of current EVA and FGV—for two very One reason this distinction between COV and FGV well-known companies, Apple and Amazon, over the years is important, as discussed in more detail below, is that the 2007-2017. steadily growing importance of intangible assets in today’s Figure 1 shows Apple’s experience of what is in fact a very common pattern: the two components of MVA often moving in opposite directions. In fact, in six of the ten years we looked 7 A more complete discussion of the EVA math is available in O’Byrne, Stephen F., “A Better Way to Measure Operating Performance (or Why the EVA Math Really Mat- at—2008, 2011, 2012, 2013, 2015, and 2016—Apple’s ters),” Journal of Applied Corporate Finance, Vol. 28 No. 3 (Summer 2016). capitalized EVA and FGV went in opposite directions. And

Journal of Applied Corporate Finance • Volume 31 Number 3 Summer 2019 133 though the annual change in Apple’s capitalized EVA explains The Apple and Amazon Challenges to the 58% of the variation in its annual FGV changes, the statistical Modern EVA Bonus Plan relationship is in fact negative: on average, each additional $1 Companies like Apple pose a challenge for the modern EVA of capitalized EVA was associated with a $0.57 reduction in bonus plan because the value of its positive EVA improve- FGV. Amazon is a much more unusual case in that its FGV is ment is frequently offset by a negative change in its FGV. consistently moving in the same upward direction as its EVA. From 2007 to 2015, Apple’s capitalized EVA increased by It’s easy to come up with explanations why FGV would $674 billion, but its FGV declined by $368 billion, or offset- decline, as it’s often done at Apple: investors expect slower ting more than half of the EVA improvement that would have growth or lower EVA margins, or the company is perceived been rewarded by an EVA bonus plan. And to the extent that as nearing the end of a finite period of competitive advantage. managerial decisions that increase EVA actually contribute It’s also easy to explain why FGV would even be negative, as to the reductions in future growth value—say, by increasing it’s been in six of the 11 years for Apple: it’s a sign that inves- prices at the expense of growth—a comp plan that rewards tors don’t believe that its current EVA can be sustained. That EVA improvement without any offset for the decline in FGV could be due to expectations of price cuts needed to meet would make management’s percentage pay premium far competitive pressures or falling sales volume as iPhones and higher than investors’ percentage excess return. other Apple products capture a larger percentage of the poten- Amazon is also a challenge for the modern EVA bonus tial market. It’s more challenging to explain why FGV might plan because it has created so much shareholder value that increase continuously, as it appears to be doing at Amazon is not now captured—and would be difficult to capture— (and we’ll use more of the EVA math below to do that). in the value of its capitalized EVA. In theory, both of these The negative relationship between changes in FGV and challenges could be addressed by carefully adjusting the EI.10 EVA that we see at Apple is very common. In 66 (GICS) For example, the expectation of positive ∆FGV associated industries I looked at, the median correlation of ∆FGV and with increases in current EVA could be accommodated by ∆EVA was -0.53.8 The FGV “offset” was particularly large in reducing the EI (or even making it negative), thereby boost- the case of companies making improvements in negative EVA. ing the bonus earned; conversely, an expectation of negative The change in FGV associated with each $1 of capitalized ∆FGV would call for raising the EI, which would reduce the improvement by negative EVA companies was -$0.49 or more bonus earned for a given level of EVA. These adjustments negative in every industry except for one.9 And the median would raise the EVA bonus at Amazon and reduce it at Apple, change in FGV associated with a $1 increase in capitalized bringing both more in line with investor excess returns. EVA for all companies with negative EVA was -$1.03. For But perhaps the biggest challenge in designing such plans companies with positive EVA, the change in FGV associated is that the abrupt changes in FGV experienced by Apple and with $1 of capitalized EVA improvement was negative in 33 Amazon suggest the difficulty, if not impossibility, of preci- of the 66 industries, with a median value of -$0.49 for these sion forecasting of FGV. After all, Apple’s FGV increased by 33 industries. almost $400 billion in the period 2015-2017 after declining But now let’s turn to those companies, like Amazon, by $368 billion in the prior seven years—and Amazon’s FGV where EVA and FGV have a positive relationship. For the 33 increased by $386 billion in the three years 2014-2017 after industries with positive ∆FGV associated with $1 of capital- increasing by only $77 billion in the previous seven years. ized improvement in positive EVA, the median value is $0.41. According to one interpretation of the Apple graph, And the five industries with the highest ∆FGV “multiples” of the modern EVA bonus plan can work well without any capitalized positive ∆EVA are Communications Equipment, modification. This view says that the annual fluctuations Internet Software & Services, Software, Commercial Services in FGV are largely “noise,” and that we should accordingly & Supplies, and Specialty Retail. As one might expect, these focus on the fact that the cumulative FGV change at Apple is are industries with strong growth trajectories; and, in such trivial—amounting to only 5% of the cumulative change in industries, every dollar of capitalized EVA improvement adds capitalized EVA over the ten-year period. more than a dollar of future growth value. But, as it turns out, the modest cumulative impact of changes in EVA on ∆FGV that we see at Apple is not repre- sentative of most companies. When I looked at ten-year 8 Based on 50,997 five-year periods for S&P 1500 companies ending in 1985-2018 and limited to GICS industries with at least 50 company five year periods available. 10 The second component of the EVA math says that EI = WACC x FGV – expected 9 The negative EVA multiple for Construction Materials (GICS 151020) is -0.12. ∆FGV, so higher expected ∆FGV leads to lower EI and vice versa.

134 Journal of Applied Corporate Finance • Volume 31 Number 3 Summer 2019 Figure 3 Figure 4 Capitalized EVA and FGV for Colgate-Palmolive Capitalized EVA and FGV for Kroger

0 30

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200 200 2009 2010 2011 2012 2013 201 201 201 201 200 200 2009 2010 2011 2012 2013 201 201 201 201 periods for S&P 1500 companies ending in 1990-2018, I ing for current EVA performance. This is where the modern found that the change in FGV was greater than 10% of the EVA bonus plan has the potential to encourage short- change in capitalized ∆EVA in about 95% of some 36,000 termism. ten-year periods.11 Ten-year changes in FGV moved in the The original EVA bonus plan—the General Motors plan same direction as ten-year changes in EVA at both Amazon mentioned earlier—took account of only the level of EVA. and Apple, but that turns out to be unusual, too. For in fully The modern EVA bonus, as developed at Stern Stewart in 70% of the cases, ten-year ∆FGV and ∆EVA went in opposite the 1990s, took account of the changes in EVA—and it directions. also took account of the initial level and expected change of FGV. But it still misses a component of investors’ excess Two More Challenges to the EVA Bonus Plan return, which depends on three things: (1) the change in Figures 3 and 4 show two well-known companies—Colgate- current EVA; (2) EI (which takes account of the initial level Palmolive and Kroger—that are drawn from the bottom half and expected change of FGV); and (3) the unexpected change of the distribution of capitalized EVA change to FGV change, in FGV.13 where the ratios are all negative.12 When the cumulative change in FGV is small, as it Colgate-Palmolive and Kroger both pose major, though was for Apple (from 2007-2017), the modern EVA bonus different, challenges for the modern EVA bonus plan. In plan can work reasonably well. But when the cumulative the case of Colgate, the plan would effectively penalize unexpected change in FGV is significant—as in the cases of the company’s declining EVA by paying below-market Amazon, Colgate-Palmolive, and Kroger—the modern EVA bonuses while ignoring the company’s rising FGV, which bonus plan can lead to critical problems, such as under- is likely reflecting investor optimism about future payoffs payment of talented executives in cases like Amazon and from the company’s strategy. Since the increase in FGV is Colgate, and rewarding short-termism in cases like Kroger. much larger than the decline in capitalized EVA, Colgate’s To adapt the modern EVA bonus plan for these more investors will have positive excess returns while its managers challenging cases, we need to answer two questions: Is it get below-market pay—a case of underpaying for superior possible to anticipate changes in FGV? And is it possi- performance. ble to find operating measures that are good proxies for In the case of Kroger, the EVA performance looks unexpected changes in FGV? To answer these questions, great, but it’s offset by declining FGV that is not captured we first need a better understanding of what drives FGV. in the bonus formula. And to the extent that Kroger’s EVA improvement resulted from decisions that also contributed Profitability and Growth Are the Drivers of to the drop in FGV, the bonus formula would be overpay- Future Growth Value To better understand the drivers of future growth value, let’s 11 Using absolute values for the changes in FGV and capitalized EVA. work through a simple example of a profitable and grow- 12 Colgate-Palmolive is in the bottom decile of ∆EVA/∆FGV ratios, roughly corre- sponding to Amazon in the top decile. Kroger is at the 30th percentile, roughly corre- sponding to Apple at the 70th percentile. 13 See O’Byrne (2016) for more detail.

Journal of Applied Corporate Finance • Volume 31 Number 3 Summer 2019 135 ing business. Start by assuming the business has beginning In earlier research, David Young and I found evidence that capital of $1,000, ROIC of 15%, WACC of 10%, and capi- the underlying problem is what we call the “delayed produc- tal growth expected to average 3% forever. EVA will be $50 tivity of capital.”16 When it takes several years for capital to [(15% – 10%) x $1,000] in year 1, $51.50 [(15% – 10%) x be fully productive, the increase in the capital charge actually 1,030] in year 2 and $53.05 [(15% – 10%) x 1,060.90] in becomes a fairly reliable precursor of and proxy for business year 3. FGV at the end of year 1 will be the present value of growth, not just an adjustment for the cost of investment. future EVA that is greater than $50. We can also express FGV as the capitalized present value Better Proxies for FGV: Expected Dollar Margin from of future annual ∆EVA, which makes it easier to calculate. Capital Growth ∆EVA in year 2 is $1.50 and grows at 3% a year thereafter. The As we saw earlier, when ROIC and WACC are both fairly capitalized present value of $1.50 growing at 3% is $235.71 constant, we can estimate ∆FGV as a multiple of the (ROIC [(1 + 10%)/10% x $1.50/(10% – 3%)]. When we do the same – WACC) spread times the expected increase (in dollars) in calculation at the end of year 2, we get FGV of $242.79. Thus, capital spending. But at the same time, we found that, for we can see that EVA increases by $1.50 in year 2 and FGV most companies, changes in EVA are generally unreliable increases by $7.08. proxies for changes in FGV in practice. This example shows that long-horizon FGV growth has In more recent research, we have gotten better estimates two basic drivers: profitability and capital growth. With an of ∆FGV by multiplying a company’s expected capital growth EVA spread (ROIC – WACC) of 5% and a capital growth (again in dollars) by a profitability “spread” that is calculated rate of 3%, we get FGV of $235.71 at the end of year 1 and before WACC and before deducting expenses associated with $242.79 at the end of year 2, an increase of $7.08. If the what we call the delayed productivity of capital. In fact, our EVA spread was 10% instead of 5%, we would get FGV of best results have come when using an ROIC measure that is $471.43 at the end of year 1 and $485.57 at the end of year calculated before depreciation, capital charge, R&D, adver- 2, an increase of $14.14. If the EVA spread was 10% and the tising, and stock compensation. All of these expenses tend capital growth rate was 5%, not 3%, we would get FGV of to have future period benefits, and hence cause a downward $1,100.00 at the end of year 1 and $1,155.00 at the end of bias in the EVA spread when no adjustment is made for such year 2, an increase of $55.00.14 benefits.17 We use industry models to estimate expected capital Delayed Productivity of Capital Is a Big Reason growth rates from historical growth rates, multiply the Why ∆EVA Is a Poor Proxy for ∆FGV expected capital growth rate by the dollar capital base to get Because EVA and FGV both increase with the profitability the expected dollar increase in capital, and then multiply that spread (ROIC – WACC) and with growth in investment, expected dollar increase in capital by the company’s adjusted we might expect the change in EVA to be the most useful ROIC spread to obtain a measure that we call the “expected proxy for changes in FGV and excess return.15 In practice, dollar margin from growth.” For example, if a company with a however, the change in EVA turns out to be no better than the capital base of $1 million is expected to grow its capital at 3% change in NOPAT in explaining differences in excess return. a year and its adjusted ROIC spread is 20%, then its expected In an analysis of 36,000 ten-year periods across 66 industries, margin from growth is $30,000 x 20%, or $6,000. I found that the change in NOPAT explained 44% of excess We use a second industry model to estimate the change returns for the median industry, as compared to 39% for the in FGV from the change in expected margin from growth. change in EVA. And since the change in EVA is the change Using these operating performance estimates of ∆FGV, we in NOPAT minus the change in the capital charge, this find- came up with significantly more accurate estimates of actual ing implies that inclusion of the capital charge actually reduces excess returns.18 explanatory power when it should be adding it. As can be seen in Figure 5, when using industry models for S&P 1500 companies in 36,000 ten-year periods from 1980 to 2018, we found that, on average, the change in EVA 14 More generally, with constant ROIC, WACC and capital growth g, expected capital explained 41% of the variation in excess returns. The addition growth is beginning capital x g, ∆EVA is (ROIC – WACC) x expected capital growth and ∆FGV is (1 + WACC)/WACC x ∆EVA/(WACC – g). 15 ROIC is rarely constant in practice. And since ∆EVA is equal to (ROIC – WACC) x 16 O’Byrne and Young (2009) above. capital growth plus ∆ROIC x beginning total capital, we can think of ∆EVA as a weighted 17 For simplicity, we use a WACC of 0% instead of estimating a “grossed-up” WACC average of spread and ∆ROIC, where the weight on spread is far less than the weight on that captures average levels of all the missing expenses, including cost of capital. ∆ROIC. 18 Our industry models also use ∆EVA+ and ∆EVA – as explanatory variables.

136 Journal of Applied Corporate Finance • Volume 31 Number 3 Summer 2019 Figure 5 Conclusion Excess Return R-Sq EVA is the only financial performance measure that ties directly to discounted cash flow value, and the EVA math that divides all companies’ value into current operations 100 Mean values of r-sq for 66 GICS industries values (COVs) and future growth values (FGVs) can be used to provide critical insights for valuation, target setting, and 0 performance analysis. EVA bonus plans have been tried again and again but without addressing a fundamental challenge— 0 the tendency of increases in current EVA to be associated with declining expectations of future EVA improvement (or reduc- 0 tions in FGV)—and the converse tendency of decreases in 59% EVA to be associated with increases in FGV. 46% 20 41% One result of this negative correlation between EVA and FGV has often been excessive rewards for EVA improvement

0 that comes at the expense of future growth opportunities—for elta VA elta VA elta VA red FV example, from pursuing margin improvements at the expense of business growth or passing up positive-NPV projects that would reduce current EVA. The solution outlined here is of EI, calculated at the start of each ten-year period, increases designed to stimulate new research on better operating proxies the r-squared to 46%. The addition of estimated ∆FGV— for change in future growth value and a reinvigoration of estimated using the change in expected dollar margin from EVA bonus plans using dynamic EI to help companies achieve growth—increases the r-squared to 59%. better alignment of management pay with contribution to While our operating models of ∆FGV thus provide an shareholder value. operating measure with significantly more explanatory power than ∆EVA alone, there is a great deal of room for improve- Stephen O’Byrne is the founder and CEO of Shareholder Value Advi- ment. Our models explain only 24% of the excess return sors, an incentive compensation consulting firm. In the 1990s, before variation that’s not explained by EVA and EI.19 The good starting his own firm, Steve ran Stern Stewart & Co.’s EVA-based compen- news is that our operating models of ∆FGV don’t go beyond sation consulting practice. operating margin and capital growth. More accurate models could, and no doubt will, be developed that make use of other variables. Among the most promising candidates are measures of customer acquisition, lifetime value, and satisfaction—and measures of employee satisfaction, turnover, and pay align- ment with company value added. One way to adapt the modern EVA bonus plan to the challenges of Amazon, Apple, Colgate-Palmolive, and Kroger cases is to incorporate a “dynamic EI.” In each year, the operat- ing model of change in FGV would be used to “true up” the EI to reflect the expected impact of the company’s operating performance on FGV from the start of the plan.20

19 (59% – 46%)/(100% – 46%) = 24%. 20 For additional discussion of “dynamic EI” see O’Byrne (2016).

Journal of Applied Corporate Finance • Volume 31 Number 3 Summer 2019 137 APPENDIX: Why MVA Is Not a Good Proxy for With different EVA accounting rules, MVA would be Investors’ Excess Return equal to the cumulative excess return. This would be the case The excess return is the dollar difference between the return if all positive EVA were treated as a distribution of capital and the company’s investors actually earned on the capital they all negative EVA were treated as a contribution to capital.23 invested, and their expected return based not on the broad To get a better sense of the practical importance of this market return, but on the company’s cost of capital. For theoretical shortcoming of MVA, I looked at the correlations example, if the cost of capital is 10% and investor’s initial between MVA and dollar excess return across 39,000 ten-year investment is $1 million, the investor’s expected wealth is periods for S&P 1500 companies. When I divided the sample $1.61 million at the end of five years and $2.59 million at the in half based on MVA as a percentage of year 10 expected end of ten years.21 MVA—which, again, is the dollar differ- investor wealth, I found startling differences. ence between a company’s current market enterprise value In the top half of the sample—where MVA is 149% of and its book capital—overstates the excess return achieved year 10 expected investor wealth, on average, MVA turns out by negative EVA companies and understates the excess return to be a reasonably good proxy for the dollar excess return. achieved by positive EVA companies because it ignores distri- MVA was only 6 percentage points higher than the excess butions during the period. Two companies can have the same return, on average, and it explained 91% of the variation in current MVA even though one company has earned and excess returns.24 distributed a 40% return on capital over the last ten years, But in the bottom half of the sample, where MVA was while the second company has earned a zero return on capital –11% of year 10 expected investor wealth, on average, MVA and distributed nothing over the last ten years.22 The investors is a largely unreliable proxy for the excess return. MVA who received the 40% return distributions are far better off was 20 percentage points higher than the excess returns, than the investors who received no distributions, even though on average, and explained only 6% of the variation in the their current MVAs are the same. excess return.

23 See Young, S. David and Stephen F. O’Byrne, EVA and Value-Based Manage- ment, McGraw-Hill, 2001, p. 42. 21 $1.61 million = (1 + 10%)^5 x $1 million. 24 In the bottom half of the sample, an incremental $1 of MVA adds only $0.60 of 22 Both companies would have the same current MVA if both now have the same excess return, while in the top half of the sample, an incremental $1 of MVA adds $1.09 ROIC. of excess return.

138 Journal of Applied Corporate Finance • Volume 31 Number 3 Summer 2019 ADVISORY BOARD EDITORIAL Yakov Amihud Carl Ferenbach Donald Lessard Clifford Smith, Jr. Editor-in-Chief New York University High Meadows Foundation Massachusetts Institute of University of Rochester Donald H. Chew, Jr. Technology Mary Barth Kenneth French Charles Smithson Associate Editor Stanford University Dartmouth College John McConnell Rutter Associates John L. McCormack Purdue University Amar Bhidé Martin Fridson Laura Starks Design and Production Tufts University Lehmann, Livian, Fridson Robert Merton University of Texas at Austin Mary McBride Advisors LLC Massachusetts Institute of Michael Bradley Technology Erik Stern Assistant Editor Duke University Stuart L. Gillan Stern Value Management Michael E. Chew University of Georgia Gregory V. Milano Richard Brealey Fortuna Advisors LLC G. Bennett Stewart London Business School Richard Greco Institutional Shareholder Filangieri Capital Partners Stewart Myers Services Michael Brennan Massachusetts Institute of University of California, Trevor Harris Technology René Stulz Los Angeles Columbia University The Ohio State University Robert Parrino Robert Bruner Glenn Hubbard University of Texas at Austin Sheridan Titman University of Virginia Columbia University University of Texas at Austin Richard Ruback Charles Calomiris Michael Jensen Harvard Business School Alex Triantis Columbia University Harvard University University of Maryland G. William Schwert Christopher Culp Steven Kaplan University of Rochester Laura D’Andrea Tyson Johns Hopkins Institute for University of Chicago University of California, Applied Economics Alan Shapiro Berkeley David Larcker University of Southern Howard Davies Stanford University California Ross Watts Institut d’Études Politiques Massachusetts Institute de Paris Martin Leibowitz Betty Simkins of Technology Morgan Stanley Oklahoma State University Robert Eccles Jerold Zimmerman Harvard Business School University of Rochester

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